1 

 2

 3

 4

 5

 6

 7

 8 

 9 

 10

 11

 12

 13

 14

 15

 16 

 17 

 18

 19

 20 

 21

 22

 23

 24 

 25 

THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION 

DIVISION OF INVESTMENT MANAGEMENT

RULE 12b-1 ROUNDTABLE

Tuesday, June 19, 2007

9:15 a.m. 

(Amended 7/24/07 and 8/15/07) 

Diversified Reporting Services, Inc. 

(202) 467-9200 

Page 1 
12b1transcript

 1 PARTICIPANTS:

 2

 3 Brad M. Barber Avi Nachmany

 4 Martin G. Byrne Charles Nelson

 5 Matthew P. Fink Don Phillips

 6 Andrew J. Donohue Richard M. Phillips

 7 Mark R. Fetting Robert E. Plaze

 8 Joel H. Goldberg Barbara Roper

 9 Richard W. Grant Joseph R. Russo

 10 Paul G. Haaga, Jr. Douglas J. Scheidt

 11 John A. Hill Thomas M. Selman

 12 Mellody Hobson Michael J. Sharp

 13 Jeffrey C. Keil Erik R. Sirri

 14 Kathryn Bradley McGrath Robert W. Uek

 15 John R. Morris Shannon Zimmerman

 16

 17

 18

 19

 20

 21

 22

 23

 24

 25

 1 C O N T E N T S

 2

 3 

Page 2 

PAGE 
12b1transcript

 4 Welcoming Remarks -- Chairman Cox 4

 5

 6 Overview -- Mr. Donohue 7

 7

 8 Panel 1: Historical Perspective 12

 9

 10 Panel 2: Current Uses: The Role of 12b-1 Plans 60

 11 in Current Fund Distribution Practices

 12

 13 Panel 3: The Costs and Benefits of 12b-1 Plans 126

 14

 15 Panel 4: Looking Ahead: What Are Our Options? 192

 16

 17

 18

 19

 20

 21

 22

 23

 24

 25

 1 P R O C E E D I N G S

 2 CHAIRMAN COX: Welcome to the Securities and

 3 Exchange Commission Roundtable on Rule 12b-1, under the

 4 Investment Company Act.

 5 To many of you who are seated here, or who are

 6 listening on the Internet today, Rule 12b-1 has a special

Page 3
12b1transcript

 7 meaning, and a long history, as least as far as mutual fund

 8 regulation is concerned. To others, Rule 12b-1 is merely an

 9 obscure reference to one item in a thick book of rules.

 10 But for the millions of Americans who invest their

 11 savings in mutual funds, Rule 12b-1 is important. If you

 12 don't appreciate the rule number, you surely will appreciate

 13 the dollar amount.

 14 Rule 12b-1 allows mutual funds to spend nearly $12

 15 billion a year in investors assets, to reimburse expenses,

 16 such as the marketing of mutual funds to other investors and

 17 administrative services. The Commission originally adopted

 18 Rule 12b-1 in 1980. At that time, the Commission noted in

 19 our adopting release that we and our staff would monitor the

 20 rule's operation closely.

 21 And if experience suggested the rule's restriction

 22 on the use of fund assets weren't strict enough, we would be

 23 prepared to act to remedy the situation.

 24 Now, with nearly three decades of experience under

 25 our belt, it's time that we take serious steps to re-evaluate

 1 the rule. Today, we have gathered an impressive group of

 2 panelists to help us take a fresh look at Rule 12b-1. I

 3 expect that they will express a wide range of views on the

 4 history and on the future of the rule.

 5 Today's discussions will help to inform the

 6 Commission, as it determines the next steps it will take,

 7 later this year. The roundtable is going to consist of four

 8 panels.

 9 The first panel will discuss the history of Rule 

Page 4 
12b1transcript

 10 12b-1. What were the circumstances that led the Commission

 11 to adopt it back in 1980? What was the original purpose of

 12 the rule, and how did the use of the rule evolve and change

 13 over the intervening years? We will hear from individuals

 14 who were intimately familiar with all of these developments.

 15 The second panel will discuss the ways that mutual

 16 funds, their investment advisers, and broker dealers

 17 currently use Rule 12b-1. We will hear about these modern

 18 business practices from a distinguished group that includes

 19 representatives of mutual fund firms, broker dealers, and the

 20 NASD.

 21 After the lunch break, the third panel will discuss

 22 the costs and benefits of Rule 12b-1. Sometimes we think of

 23 cost benefit analysis as applying to new rules and

 24 amendments. But it also applies to rules that have been on

 25 the books for years. On this panel, we will hear from

 1 experts who can speak to the economic effects of Rule 12b-1,

 2 from an academic, as well as a business perspective.

 3 Finally, the fourth panel will discuss the various

 4 options the Commission will have, going forward. The

 5 panelists will consider a number of cutting edge questions. 

6 Should 12b-1 be rescinded? Should it be revised, or revised

 7 only on the margin? Should the money that broker dealers

 8 receive come not from fund assets, but directly from

 9 investors, out of their brokerage or mutual fund accounts? 

10 Is there a different way to disclose these payments to

 11 investors, that is more understandable? On this panel, we

 12 will hear from those who have thoroughly analyzed these 

Page 5 
12b1transcript

 13 issues, with regard to mutual funds, broker dealers, and

 14 investors.

 15 On behalf of the Commission and our staff, I would

 16 like to thank our panelists who have devoted the time and the

 17 energy that I know that you have invested in order to be

 18 here, and help us grapple with these issues.

 19 I look forward, as do all the commissioners, to

 20 your insights at today's roundtable, as we go forward in this

 21 important area.

 22 With that in mind, I would like now to turn it over

 23 to Doug, who will help us moderate this panel, and to Buddy

 24 Donohue, the director of the investment division, for his

 25 opening remarks.

 1 MR. DONOHUE: Thank you, Chairman Cox. Thank you

 2 all for being here today, at our roundtable on 12b-1. Before

 3 I begin, I need to note that the views expressed by me, and

 4 all SEC moderators throughout the day, are our own, and do

 5 not necessarily reflect the views of the Commission, or our

 6 colleagues on the staff at the Commission.

 7 In fact, as moderators, we may at times ask

 8 questions or make statements that do not necessarily reflect

 9 our personal views, but are, instead, designed to elicit an

 10 insightful dialogue. We hope these questions will contribute

 11 to a meaningful and constructive discussion regarding Rule

 12 12b-1.

 13 I am pleased to see the interest that Rule 12b-1

 14 has generated among our panelists and audience members, and

 15 those who are joining us by webcast from their homes and 

Page 6 
12b1transcript

 16 offices. I have a personal interest in the rule, as well,

 17 because I have lived with the rule throughout its existence.

 18 When I began my career in 1975, mutual funds had

 19 $50 billion in assets under management. During that decade,

 20 in 7 of 8 years between 1972 and 1979, funds experienced

 21 significant net outflows. At the time, the Commission

 22 generally prohibited funds using fund assets to pay for the

 23 sale of its shares, out of concerns about the inherent

 24 conflicts of interest in such arrangements.

 25 In view of the market conditions of the time,

 1 however, some petitioned the Commission to reverse its

 2 long-standing position, and permit funds to use a small

 3 portion of fund assets to pay for advertising and selling.

 4 This, it was argued, would benefit shareholders,

 5 because advertising and selling efforts would increase fund

 6 assets, and increasing fund assets would have the effect of

 7 decreasing fund expense ratios. And with a more stable asset

 8 base, would enable fund managers to better manage their

 9 portfolios.

 10 Following hearings and several rounds of public

 11 comment, the Commission concluded that there may be

 12 circumstances under which it would be appropriate for a fund

 13 to bear its distribution expenses. The Commission was

 14 willing to test the notion that increased fund assets would

 15 benefit shareholders by creating better economies at scale,

 16 and a more stable asset base.

 17 In addition, there was some recognition that small

 18 12b-1 fees could subsidize the marketing and advertising 

Page 7 
12b1transcript

 19 expenses of the growing legion of no-load funds, and thereby

 20 promote healthy competition between no-load funds and

 21 broker-sold funds.

 22 Thus, in 1980, the Commission adopted Rule 12b-1,

 23 to permit funds to use fund assets to finance distribution,

 24 subject to the control and supervision of fund directors.

 25 Admittedly, this is not a very nuanced description

 1 of events, but I shall leave it to the first panel to give us

 2 the inside story on how and why 12b-1 was adopted. I raise

 3 the subject, only to show that we have come a long way from

 4 1980.

 5 Today, it is hard to imagine a time when people

 6 were concerned about net redemptions and mutual funds. Since

 7 the Commission adopted Rule 12b-1 mutual funds experienced a

 8 period of tremendous growth, with almost uninterrupted

 9 increases in sales and assets. The industry is thriving.

 10 As of the end of 2006, assets under management

 11 exceeded $10 trillion. Funds now serve as a primary

 12 long-term investment vehicle for almost half of all

 13 Americans, and account for almost a quarter of all financial

 14 assets of U.S. households.

 15 The use of 12b-1 has similarly experienced dramatic

 16 growth during this period. Approximately two-thirds of all

 17 mutual fund classes have adopted 12b-1 plans, and over 90

 18 percent of load share classes have 12b-1 plans.

 19 In the early 1980s, shareholders paid a few million

 20 dollars in 12b-1 fees. In 2006, they paid almost $12 billion

 21 in 12b-1 fees. The use of 12b-1 fees also has shifted from 

Page 8 
12b1transcript

 22 the limited marketing and advertising purposes that were

 23 originally envisioned.

 24 Now, the nearly $12 billion that shareholders pay

 25 annually in 12b-1 fees are used primarily as a substitute for

 1 a sales load, or to compensate brokers for servicing their

 2 clients, uses that are much different from what the

 3 Commission originally intended when adopting the rule.

 4 Although there is much room for debate on Rule

 5 12b-1, which will be made abundantly clear today, most

 6 observers agree that there is a disconnect between how the

 7 rule is supposed to operate, and how it used today. As I have

 8 said before, one would be hard-pressed to believe that Rule

 9 12b-1 wouldn't benefit from at least a tune-up.

 10 As Chairman Cox previously remarked, when the

 11 Commission adopted Rule 12b-1, it noted that it would monitor

 12 the operation of the rule, and be prepared to address the

 13 rule if the circumstances or experience warranted. In view

 14 of the changes in the mutual fund market, and the role of

 15 12b-1 in fund distribution practices, the Commission is

 16 re-examining the rule, to evaluate whether it continues to

 17 benefit mutual fund shareholders, or whether it would profit

 18 from re-consideration.

 19 This roundtable is part of a deliberative process. 

20 In putting together a roundtable, we made an effort -- and I

 21 believe a successful one -- to bring together representatives

 22 from a wide variety of interested groups, to share their

 23 perspectives and insights on the issues that we are examining

 24 today. 

Page 9 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

 25 

12b1transcript

We are fortunate to have so many esteemed and 

distinguished panelists, all of whom are steeped in the 

issues, participate in the panel today. And I expect that, 

given the wide range of views that are represented here, we 

will have a highly engaging, informative, and constructive 

dialogue about the issues surrounding Rule 12b-1. 

We realize that there are limitations to the 

roundtable format. There are only so many seats at the 

table, and at the auditorium. But in this day and age, this 

is just a minor inconvenience. The roundtable is being 

webcast over the Commission's web site, so that people all 

across the country can observe the proceedings. 

In addition, we are asking -- in fact, we are 

strongly encouraging -- members of the public to tell us 

their views on the issues discussed by the roundtable today, 

or any other issues related to the use of fund assets to pay 

for distribution. All interested persons can submit comments 

on the Commission's web site at www.sec.gov. We will keep 

the comment period open for a full month, until July 19th. 

As many of you know, this is not the first time the 

Commission has considered changes to Rule 12b-1 since it was 

adopted. Some have questioned whether there will be a 

serious re-examination of the rule at this time. I can 

assure you that the division of investment management is not 

only serious about the reconsideration of Rule 12b-1, it is a 

top priority for us. 

Page 10 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

The market has changed around us, and we can't 

ignore that. Because there is a long history associated with 

Rule 12b-1 and its use, however, we want to be sure that our 

review is comprehensive, and that the recommendations we make 

to the Commission about whether and how to reform the rule 

reflect the true understanding of all the issues involved. 

With your assistance, with the benefit of your comments and 

your insights, we believe that these efforts will result in 

the best possible outcome. 

As you are all aware, putting together an event of 

this magnitude is no easy task. And there are several staff 

members from my division who have worked tirelessly to 

organize today's roundtable. The team was led by Penelope 

Saltzman, and Thu Ta, and they were ably assisted by Carol 

Bartman, Jennifer McHugh, and Karen Rossotto. I greatly 

appreciate all of their efforts. 

In addition, I would like to thank Eric Sirri, Bob 

Plaze, and Doug Scheidt, who will be serving as moderators 

during today's discussions. 

With that, it is my pleasure to turn to Doug 

Scheidt, the division's chief counsel, and the moderator for 

our first panel. Thank you. 

PANEL ONE -- HISTORICAL PERSPECTIVE 

MR. SCHEIDT: Thank you, Buddy. And everyone, 

welcome to the first panel of today's roundtable on 12b-1.

As Chairman Cox stated, the first panel will focus 

Page 11 

 1 
12b1transcript

 2 on historical circumstances that led to the adoption of

 3 12b-1, the original intended purpose of the rule, and how the

 4 use of the rule evolved over time.

 5 The panelists today are a distinguished group. All

 6 of them played an important role in the events leading up to

 7 and including the adoption of Rule 12b-1, or the evolution of

 8 Rule 12b-1 plans, thereafter.

 9 In no particular order -- although it does work

 10 from my far right to my left -- the first panelist, Matt

 11 Fink. Matt Fink was a long-time representative of the

 12 Investment Company Institute, which is the trade association

 13 for the mutual fund industry. Matt served in various roles

 14 for the ICI, including as its president. He currently serves

 15 as a fund director.

 16 Second panelist, Joel Goldberg. Joel served on the

 17 staff of the division of investment management in the 1970s

 18 and 1980s, and served as the director of the division in 1981

 19 and 1982.

 20 Dick Grant served as a special counsel to the

 21 director of the division of investment management, and he

 22 served as an associate director in the division in the late

 23 1970s and early 1980s. He was a principal architect of Rule

 24 12b-1.

 25 And last, but by no means least, Kathie McGrath. 

1 Kathie McGrath served as a division -- director of the

 2 division of investment management from 1983 to 1988.

 3 We will start our panel today with Joel Goldberg,

 4 who will begin the discussion of the historical circumstances 

Page 12 
12b1transcript

 5 that led to the adoption of 12b-1. And Joel will cover,

 6 among other things, how the distribution of fund shares was

 7 financed before Rule 12b-1, what the historical position of

 8 the Commission was towards the use of fund assets for

 9 distribution.

 10 And so, Joel, take it away.

 11 MR. GOLDBERG: Thank you, Doug. I would like to

 12 start by disposing of one of the myths surrounding the

 13 adoption of Rule 12b-1. The myth is that Rule 12b-1 was

 14 adopted in response to concerns about net redemptions. In

 15 fact, net redemptions had ceased long before Rule 12b-1 was

 16 proposed or adopted. It had nothing to do with it.

 17 There was a confluence of events that led the

 18 Commission to reconsider its historic position that mutual

 19 funds should not pay for distribution. The first of these

 20 events, which received little public notice at the time, was

 21 a no-action request from a company called Armstrong

 22 Associates. It was a broker-dealer in Texas, had a no-load

 23 fund, which had never reached economic size.

 24 And Armstrong Associates came in for a no-action

 25 letter, asking for permission to use half of their advisory

 1 fee to pay broker-dealers what we would now call a trail. 

2 They didn't call it that then, but pay half of their advisory

 3 fees to broker-dealers to get them to sell shares of a

 4 no-load fund, and keep shareholders invested.

 5 The fund had been in existence for a number of

 6 years. The advisory fee, although a little bit on the high

 7 side, had not been increased, it was what it had always been. 

Page 13 
12b1transcript

 8 The staff said, "Well, there is no basis for us to say that

 9 they can't use half their advisory fee however they want;

 10 it's their money." So the staff gave Armstrong the no-action

 11 letter.

 12 This was in 1976, before there was electronic

 13 research. It was in its infancy then. And very few people

 14 were aware of the Armstrong letter. It was a public letter,

 15 but nobody heard about it.

 16 About a year later, the sponsors of two newly

 17 formed money market funds were casting about for ways to

 18 incent broker-dealers to place customers' cash in their

 19 funds. One of these funds, called "Mutual Liquid Assets,"

 20 requested no action permission to give half of its advisory

 21 fee to broker-dealers who sold shares of the funds. You

 22 know, the staff obviously recognized the similarity to

 23 Armstrong Associates. The only material difference was,

 24 Mutual Liquid Assets was a newly formed fund. So you

 25 couldn't be sure that the advisory fee would have been the

 1 same if they weren't giving up half of it. But the fee was

 2 in the range of what other money funds were charging at the

 3 time, which was 50 points.

 4 So, the staff gave Mutual Liquid Assets the

 5 no-action letter. In those days, no-action letters remained

 6 non-public for 30 days after being issued. So we had a brief

 7 period of peace.

 8 While we were in that quiet period, the staff was

 9 processing a registration statement from another money market

 10 fund called "Banner Ready Resources." It was sponsored by 

Page 14 
12b1transcript

 11 Blythesman Dillon. And Banner Ready Resources wanted to do

 12 the same thing we already told Mutual Liquid Assets they

 13 could do, which was keep 25 points of an advisory fee, pay 25

 14 points to the broker-dealer.

 15 The only difference between that and Mutual Liquid

 16 Assets was that they said, in effect, "Look, we don't want to

 17 pretend that we have a 50-point advisory fee, and we're

 18 paying half of it over -- we want to disclose exactly what

 19 we're doing, which is we're charging 25 points for investment

 20 advice, and paying 25 points from the fund to broker21 dealers."

 22 That put the staff in a funny position, you know. 

23 We really didn't want to say, "No, no, this is only okay if

 24 you pretend you're not doing it." And while we were

 25 pondering that conundrum, the industry got wind of the Mutual

 1 Liquid Assets letter. The Investment Company Institute

 2 hyperventilated.

 3 The commissioners were flooded with mailgrams and

 4 telegrams saying that, in effect, "Yes, although we have

 5 often said mutual funds should be permitted to pay for

 6 distribution, the staff is changing the rules in the middle

 7 of the game. You should do this by rule-making, you can't do

 8 it by a no-action letter."

 9 The Commission then did something which, as far as

 10 I know, has not happened before or since, which instructed

 11 the staff to withdraw the Mutual Liquid Assets no-action

 12 letter. That's my personal claim to fame. I signed the only

 13 no-action letter which was ever withdrawn by the Commission. 

Page 15 
12b1transcript

 14 And in the same release, announcing that the Commission

 15 announced it was holding hearings, and the rest, as we say,

 16 is history.

 17 MR. FINK: Can I ask Joel a couple of questions?

 18 MR. SCHEIDT: You certainly can.

 19 MR. FINK: I gather you're saying these were the

 20 predecessors to the rule-making, right? These were the

 21 models --

22 MR. GOLDBERG: Yes, yes, correct.

 23 MR. FINK: I have a couple of questions. We have

 24 heard some statements about 12b-1 in the media, particularly. 

25 One is that it was meant to be temporary. Were these three

 1 funds -- Banner, Mutual Liquid Assets, Armstrong -- were they

 2 saying, "Gee, we're going through a tough time now, let us do

 3 it just for this period?"

 4 MR. GOLDBERG: No, no, absolutely not. Armstrong

 5 Associates was making the argument that they just couldn't

 6 get their fund to an economic size, but they never suggested,

 7 once they reached a certain size, they would stop paying.

 8 MR. FINK: Secondly, did they say, "We're doing

 9 this just while the industry is in this period of net

 10 redemption. This is all just to cure net redemption issues."

 11 MR. GOLDBERG: Net redemptions had stopped by that

 12 time, it wasn't an issue.

 13 MR. FINK: Third, did they say, "We're just going

 14 to use it for advertising, and not pay dealers"?

 15 MR. GOLDBERG: All three intended to pay dealers.

 16 MR. FINK: I just wanted to say, because when you 

Page 16 
12b1transcript

 17 read a lot in the media, people say, "Gee, this was done in

 18 response to net redemptions, it was meant to be temporary, it

 19 was meant to be used for advertising, and not to pay

 20 dealers." But at least the three predecessors of the rule,

 21 the three models, or whatever we want to call it, were not to

 22 be temporary; were not aimed at net redemptions; and were

 23 paying dealers.

 24 MR. GOLDBERG: But I think it's important to

 25 emphasize, Matt, the reason the staff took the position it

 1 did on Armstrong and Mutual Liquid Assets, and would have

 2 taken it on Banner, if we had had the chance, was because the

 3 intellectual flaw in the position that funds can't pay for

 4 distribution had come to the surface.

 5 We had always said -- the Commission always

 6 said -- mutual funds can't pay for distribution. But these

 7 three -- Armstrong, first, Mutual Liquid Assets, and then

 8 Banner -- showed that was an intellectually indefensible

 9 position. You couldn't do it.

 10 MR. FINK: And here, I always thought it was the

 11 institute pleading net redemption.

 12 MR. GOLDBERG: Well, that also helped.

 13 MR. FINK: I guess --

14 MR. SCHEIDT: Joel, what were the reasons for the

 15 Commission's direction to you to withdraw the no-action

 16 position? What were the concerns underlying the Commission's

 17 views?

 18 MR. GOLDBERG: You mean the position that you

 19 shouldn't pay for distribution? 

Page 17 
12b1transcript

 20 I think the Commission had always been concerned,

 21 rightly, that there was a conflict of interest. Clearly, the

 22 promotion of sales is good for the investment adviser,

 23 because the advisory fee is a percentage of assets, right? 

24 The bigger the fund, the bigger the advisory fee.

 25 If mutual funds were allowed to pay for

 1 distribution, the Commission was concerned that the benefits

 2 to shareholders would be questionable, at best. But there

 3 would clearly be a benefit for the adviser.

 4 And, of course, Rule 12b-1 didn't exist at that

 5 time, so there were no requirements about directors approving

 6 it, and all of that.

 7 MR. SCHEIDT: So, what happened next?

 8 MR. GRANT: I think I take my cue from that one. 

9 The Commission, as Joel mentioned, did initiate a rule-making

 10 process. It was an arduous one, and one that took a long

 11 time. It was five releases over a period of four years.

 12 As Joel mentioned, accompanying the withdrawal of

 13 Mutual Liquid Assets, the Commission put out a release. It

 14 was numbered 94-70 -- you can tell how long ago it was -- it

 15 was October 4, 1976, announcing that hearings would be held

 16 the next month, in November.

 17 The issue was described as the appropriateness of

 18 mutual funds bearing distribution expenses, directly or

 19 indirectly, a concern that existed then, and has existed over

 20 the intervening 30 years, and still exists.

 21 And I see I'm about to sound a theme that's going

 22 to get sounded over and over again, the specific examples of 

Page 18 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 23 the types of expenses that might be incurred that were listed

 24 were advertising and compensation for dealers.

 25 As background in this very brief release, the SEC 

said that it had questioned the propriety of mutual funds 

bearing distribution expenses, citing the statement of the 

future of the securities markets, which was, I guess, issued 

in 1972. As noted, the Commission withdrew the Mutual Liquid 

Assets letter. The hearings were then held on five days in 

November, and it was the following August before the 

Commission was heard from again. 

Another brief release -- the number is 99-15, the 

date is August 31, of 1977, and the SEC briefly but clearly 

said, "We haven't changed our position yet. We think that 

any plans for mutual funds to use their own assets to finance 

distribution would require a Commission order. And people 

who proceed differently do so on their own risk," which I 

thought was a fair warning to people, not to get ahead of the 

Commission on this. 

The SEC briefly characterized the views that had 

been expressed at the hearings as divided between those who 

thought there were circumstances under which fund 

shareholders could benefit from sales of shares -- and this, 

again, was focused not on whether the mutual fund business 

was in trouble, because of net redemptions, although 

certainly that had been a serious concern, it was on the 

question of whether, on an ongoing basis, shareholders could 

benefit from having their own assets spent on distribution. 

But the SEC also noted that there were plenty of 

Page 19 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

people whose view was that selling shares primarily 

benefitted management, that management had significant 

conflicts of interests in making any recommendation about the 

expenditure of fund assets, and that that would be a problem 

in any rule-making that ensued. 

So, the next step was in May of 1978, and it was 

eloquently titled, "An Advance Notice of Proposed 

Rule-Making." In other words, the Commission still wasn't 

ready to move forward, wanted to hear more from the public on 

basic concepts as to whether this would be an appropriate 

thing to do, and if so, what sort of regulation ought there 

to be. 

The Commission did indicate that they would suggest 

some alternatives in order to provide structure for the 

comments. And I don't think I mentioned that was release 

10-252, the date is May the 23rd. 

The Commission elaborated a little bit on its view, 

as to the general tenor of the comments that had been 

received during the hearings. Problems had been noted about 

the industry experiencing net redemptions for a significant 

period of time, but there were also concerns about the small 

size of many funds, as to whether they were large enough to 

be viable on an ongoing basis, and a perception that there 

was a growing resistance to paying high front-end loads. 

And in those days, as Buddy pointed out, the 

Page 20 
12b1transcript

 1 industry was still pretty small, and the choice was either a

 2 no-load fund, with no special provision made for financing

 3 the shares, distribution of the shares, or very high

 4 front-end load.

 5 There were assertions that, in addition to

 6 addressing these kinds of problems, again, that there could

 7 be benefits, on an ongoing basis, in the distribution effort,

 8 because it was in the interest of funds to grow, to maintain

 9 their size. There was a natural attrition of funds, because

 10 in the absence of any selling, on average, the funds would be

 11 gone in five years or so, because of steady patterns of

 12 investor redemption that are pretty constant, even today.

 13 The advance notice of proposed rule-making said

 14 there were three objectives to any rule-making that would

 15 follow. One was minimizing the inherent conflicts of

 16 interest -- again, the management has a clear interest in

 17 having the fund itself bear a part of the burden of selling

 18 the shares.

 19 There would be clearer interest in putting the

 20 decision and the oversight of any such expenditures in the

 21 hands of the directors, especially the independent directors,

 22 and the shareholders.

 23 And there would be an objective to ensure that all

 24 shareholders -- including existing shareholders who had

 25 already basically paid the admissions price to get into the

 1 fund -- that everybody should be treated fairly.

 2 The Commission indicated that it would proceed with

 3 rule-making, and it did proceed with rule-making, under 

Page 21 
12b1transcript

 4 section 12b of the 1940 Act, which is, of course, what they

 5 ultimately did.

 6 The Commission asked for comments about the types

 7 of expenses that might be permitted. The examples that were

 8 listed were cash payments to dealers, advertising, and

 9 payment for prospectuses used with prospective investors, as

 10 opposed to existing investors.

 11 In connection with the notion of cash payments to

 12 dealers, the Commission specifically asked whether there

 13 should be a distinction between what they characterized as

 14 transaction fees -- sales loads and similar expenses paid in

 15 connection with the transaction -- and those transaction fees

 16 and payments to third parties for distribution services,

 17 particularly to dealers in fund shares.

 18 I guess I'm going to be the third person on the

 19 panel to emphasize this particular point -- and not that

 20 that's a surprise; I think we all had it in mind -- a number

 21 of people in a number of ways have questioned whether the

 22 Commission anticipated or intended that payments to dealers

 23 would become part of the framework of the cost of selling

 24 fund shares. And the answer to that question is, absolutely.

 25 The Commission understood that, the Commission

 1 expected that. And as a person who lived with this

 2 rule -- and, in fact, had designing such a rule in my job

 3 description at one time -- I can tell you it was my main hope

 4 that, if such a rule was done, its major benefit would be the

 5 reduction -- and, in some cases, the elimination -- of

 6 front-end sales loads. 

Page 22 
12b1transcript

 7 The Commission also addressed the issue of indirect

 8 use of fund assets, which again, continues to be a hard one

 9 for people to get a hold on. It's particularly an ongoing

 10 struggle for directors, because the Commission then, as it

 11 does today, and always has, acknowledged that third parties

 12 who would have an interest in the mutual fund's shares being

 13 sold were entitled to use their own resources to fund that

 14 distribution.

 15 The problem would arise, however, if, in fact, that

 16 party -- and the Commission usually spoke in terms of the

 17 investment adviser using its assets to fund distribution,

 18 because it was the investment advisers who were doing most of

 19 the subsidization of the sale of fund shares, and it was the

 20 advisers who were receiving the largest compensation from the

 21 fund.

 22 But it was only an example. And if the question

 23 was related to any third party using its own resources for

 24 distribution, where that party had received compensation from

 25 the fund, the Commission said it would be important for the

 1 board to satisfy itself that the fee was fair, and had been

 2 set without making any allowance in the fee for the advisers'

 3 expenditure for distribution. And that same theme was

 4 sounded, I guess, in virtually all the releases thereafter,

 5 although the wording changed over time, as the Commission

 6 tried to clarify the intent.

 7 It was over a year before a rule proposal appeared. 

8 That was September 7, 1979, the release number is 108-62. 

9 The Commission noted that there had been 50 comments on the 

Page 23 
12b1transcript

 10 advance notice of proposed rule-making, 20 that were in favor

 11 of the use of fund assets for distribution, and 30 that were

 12 opposed.

 13 I'm not going to go through -- and you will all be

 14 grateful that I am not going to go through -- the comments in

 15 any detail. Because, the fact of the matter is, they really

 16 didn't form the basis of the Commission's rule-making. I

 17 think it's fair to say that the staff of the division of

 18 investment management thought that it was necessary to have a

 19 fresh approach.

 20 At that point, basically nothing had worked. In

 21 fact, I think we could have gone even further back in history

 22 to try to find efforts to deal with the issue of spending

 23 fund assets on distribution.

 24 MR. GOLDBERG: Dick, I would like to correct one

 25 thing I said, if I could interrupt you for a moment.

 1 MR. GRANT: That's never happened before, Joel.

 2 MR. GOLDBERG: Matt Fink, not for the first time,

 3 has pointed out that I said something incorrect. I said that

 4 net redemptions had ended by 1976. In fact, he just gave me

 5 a whole sheet of numbers here, showing that they continued

 6 pretty much through 1980.

 7 But I would still tell you that that had nothing to

 8 do with any of the events, as far as I was concerned, leading

 9 to 12b-1.

 10 MR. GRANT: Well, I think that's a fair point. The

 11 Commission actually observed, in the 1978 release, net

 12 redemptions seemed to have ended. But it wasn't deterred, in 

Page 24 
12b1transcript

 13 going down the road of addressing this issue.

 14 I think that's further evidence that the resolution

 15 the SEC was looking for was a permanent one to this issue.

 16 MR. GOLDBERG: And isn't it really that when you

 17 couple funds paying for distribution with the sort of

 18 undeniable permissibility of the management paying for

 19 distribution -- when the management gets its money, guess

 20 where, from the fund -- it is really very difficult

 21 to prevent mutual funds from paying for distribution. What

 22 you can do is to regulate it.

 23 MR. GRANT: Well, you know, I think you have to be

 24 realistic. It costs money to sell things, and it doesn't

 25 matter whether it's a can of beer or a mutual fund share. 

1 There are going to be people involved in the process.

 2 Today, there is wide availability of no-load funds,

 3 and yet most people are still buying their shares outside of

 4 retirement plans and the like by paying somebody who is a

 5 salesman or an adviser, however you would like to

 6 characterize it.

 7 MR. FINK: You spared us reading the comment

 8 letters, and I don't want to force the audience to listen to

 9 these, but not only was it clear from the commentators, that

 10 they expected to be paying dealers; a number of them said

 11 they expected to get rid of front-end loads if and when a

 12 rule was adopted, and go to continuous fees.

 13 I actually came out of the retirement home and went

 14 down to the Institute a couple of weeks ago, and read the 800

 15 pages of the 1976 transcript. And this is IDS, the largest 

Page 25 
12b1transcript

 16 fund group in 1976. It was the Fidelity, or the Vanguard of

 17 the American funds at that time.

 18 This is Hamer Budge, former SEC chairman, chairman

 19 of the IDS board, "It is the judgement of the board of

 20 directors, and of IDS, the management company, based upon its

 21 long experience in selling financial products, that the sales

 22 load charge investors at the time of purchase should be

 23 eliminated. There appears to be no way of doing this, except

 24 to have the investor pay for sales distribution during the

 25 life of his investment, rather than paying an initial sales

 1 load at the time of investment. It seemed to us that the

 2 straightforward solution would be to impose a direct charge

 3 on the funds assets to pay for these efforts."

 4 The Institute also submitted a brilliant comment

 5 letter by Matthew P. Fink, general counsel, which said, "We

 6 can foresee funds electing to supplement existing sales loads

 7 with the use of fund assets for distribution expenses. We

 8 can just as easily foresee funds electing to decrease or

 9 eliminate sales loads if fund assets are used for

 10 distribution expenses."

 11 So, these were -- as the rule was being -- people

 12 were well aware it was going to be used to pay dealers, as

 13 you said. And people also thought about one of the

 14 options -- there were different options.

 15 One was to supplement the load, like we have for A

 16 shares today. We have a load plus a 25 trail. Or, B and C

 17 shares, where there is no load, there is a continuous fee. 

18 And at least people in the industry said, "If you adopt a 

Page 26 
12b1transcript

 19 rule, that's what we plan to do."

 20 MR. GRANT: Matt, I would like to say --

21 CHAIRMAN COX: I'm sorry, I wonder if I could just

 22 interject at that point, because there had been a fair amount

 23 of discussion just now about what was intended back in 1980. 

24 And it may or may not matter, but I have a letter before me

 25 here from ICI of May 2004, a comment letter on 12b-1. And

 1 it's signed, not by a general counsel, Matthew P. Fink, but

 2 by President Matthew P. Fink.

 3 And it says, "Mutual fund distribution practices

 4 have changed dramatically since Rule 12b-1 was adopted in

 5 1980. Most notably, the predominant use of 12b-1 fees for

 6 most of their history has been as a substitute for front-end

 7 sales loads, and/or to pay for administrative and shareholder

 8 services that benefit existing fund shareholders. Although

 9 these uses were not anticipated when the rule was first

 10 adopted."

 11 MR. FINK: I have no recollection of that letter.

 12 (Laughter.)

 13 MR. FINK: That's the reason I retired, Mr.

 14 Chairman.

 15 CHAIRMAN COX: I think all of this history is

 16 extremely useful. And, you know, in fairness to President

 17 Fink -- at the time -- the point you're making in that letter

 18 is that, intended or not, ICI and you believe that those uses

 19 are completely consistent with the original purposes of the

 20 rule. And I think what we're examining here, and what we're

 21 bringing out, suggests that that may well be the case. 

Page 27 
12b1transcript

 22 MR. FINK: Mr. Chairman, I might just say

 23 this -- and I don't know if it's a full explanation -- I

 24 think -- and we're about to get to it; I don't want to cut

 25 into Kathie's time -- I think what we anticipated --

1 advertising, payment for prospectuses for non-shareholders,

 2 payments to dealers, either supplementing or

 3 replacing -- what we didn't foresee was the contingent

 4 deferred sales loads, which let amounts be paid that were

 5 equal to the front-end load.

 6 I think that was the -- and that may have been, if

 7 I had to justify -- which I don't have to any more -- but if

 8 I had to, I think that's what surprised all of us. We're

 9 going to get to that in a minute, but that was the

 10 event -- it's now called B shares -- that at least Dave

 11 Silver, who was president of the Institute, and I think other

 12 people, were very surprised about.

 13 MR. GOLDBERG: And, you know, what's interesting

 14 about that, Matt, is we shouldn't have been surprised,

 15 because the insurance industry had been using that method of

 16 financing sales commissions for many years. They had

 17 mortality and expense charges, and they would advance the

 18 sales commission to the salesman, pay it back through the

 19 M&E.

 20 But I agree with you. Certainly no one on staff, I

 21 think, ever thought --

22 MR. FINK: We also thought it wouldn't survive. I

 23 remember the day -- I can't remember what I had for lunch

 24 yesterday, but I can remember clearly, when we saw that, we 

Page 28 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 25 said, "Oh, boy, this is going to have a life of about a 

half-a-day." 

MR. SCHEIDT: Let's further test our memories, and 

get back to 1979. 

MR. GRANT: I will pick up the --

MR. SCHEIDT: And one thing I wanted to ask about 

other things that were going on at the time, while the 

Commission and the staff were considering Rule 12b-1, there 

were the Vanguard proceedings, and there were -- there was a 

general trend, after the 1970 amendments, which put the focus 

more on independent direct fund directors -- there was an 

increasing reliance by the Commission on the independent 

directors of funds to police conflicts of interest. 

MR. GRANT: Doug, let me sort of pick up the 

thread, and talk a little bit about the dynamic. 

As I mentioned before, the rule reflected kind of a 

fresh start, if you will, rather than something that flowed 

out of the various hearings. 

Internally, there was a continuing struggle, if you 

will, over this issue. As I have indicated, the Commission, 

went sort of on record, saying that it was generally 

inappropriate for funds to use their own assets for 

distribution. Internally, the division of investment 

management was looking for an answer, but certainly concerned 

about the conflicts of interest, and how those could be 

regulated. 

Page 29 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

The division of enforcement was adamantly opposed 

to giving an inch. Two of the commissioners were equally 

adamantly opposed --

MR. GOLDBERG: Do I recall the division of 

enforcement threatened to bring a 2(e) proceeding against 

you? 

MR. GRANT: I think they threatened to send me to 

jail. It was others who just were going to be 2(e)'d. 

But they fought it tooth and nail. The general 

counsel had considerable questions about some of the legal 

issues that were posed by the Commission's authority in the 

proposed approach, and so they were, you know, kind of on the 

fence. I would say an "annoyance," but that would be 

impolite, so I won't say that. 

One thing that was going on -- to pick up on Doug's 

comment -- was that the division heads started kind of a 

regulatory reform program with the support -- I might say 

"prodding" -- of the then-Chairman Harold Williams. And the 

essence of it was to identify areas that were regulated that 

reflected business judgements, and to allow those business 

judgements to be made by the fund, with significant input and 

oversight from the independent directors. 

So, we sort of picked that theme up with a rule, 

and added to that a sort of concept of a -- made it 

basically, a procedural rule, rather than one that sought to

regulate the kinds or amounts -- the kinds of expenses, or 

Page 30 

 1 
12b1transcript

 2 the amounts that could be spent on distribution to have a

 3 rule follow a process calling for approval by the directors

 4 and by the shareholders, at least in the case of a new plan

 5 for an existing fund, all with the oversight of the

 6 independent directors.

 7 And, in fact, that process was designed to reflect,

 8 or be very similar, to the process that funds have to go

 9 through anyway, in the approval and annual renewal of

 10 investment advisory agreements, and with agreements with the

 11 principal underwriter, the idea being that all those

 12 decisions can be considered, collectively.

 13 The rule was put out by a three-to-two vote, the

 14 chairman providing the third vote, and I think he was

 15 basically really willing to hear what the public had to say. 

16 And I think he might have voted the other way, had it not

 17 been for the fact that he was the one who was promoting this

 18 regulatory reform idea, in the first place.

 19 The comment was hostile. I think that's really the

 20 only word for it. And, Matt, I wanted to say that your

 21 comment letters were frequently brilliant, and almost always

 22 painful for the recipient. I remember them well.

 23 But, ironically -- and I'm only half facetious when

 24 I say this -- I think the two commissioners who were most

 25 reluctant were persuaded. One of them said, although with a

 1 smile, that, "Well, if they hate it that much it can't be as

 2 bad as I thought it was."

 3 So, the Commission maintained the basic structure

 4 of the rule, and you know, tweaked a few things, and adopted 

Page 31 
12b1transcript

 5 it. The release is 11-414, the date is October 28, 1980.

 6 And just sort of three final comments about the

 7 rule, as it was adopted. Again, the Commission tried to

 8 address the issue of direct versus indirect. That is, to

 9 what extent can the adviser, or other third-party recipient

 10 use its own assets to promote distribution.

 11 The Commission again said, "You know, there can't

 12 be an allowance in the fee for distribution, there can't be

 13 inflation of the fee for distribution, there can't be an

 14 arrangement that a third party who receives money from the

 15 fund is acting as a conduit" -- I guess I should say a second

 16 party is acting as a conduit for payments through.

 17 But the bottom line was that if the fee met the

 18 applicable legal standard -- in the case of advisory fees, it

 19 is, of course, section 36B -- the recipient of that fee could

 20 use the assets, use its resources as it saw fit.

 21 Second thing on the role of the board, the

 22 Commission stressed that this was a business decision,

 23 stressed the Commission was not going to regulate the amount

 24 or the nature of 12b-1 fees. A clear expectation that people

 25 would use their imagination in coming up with things that

 1 were, in fact, not anticipated at the time.

 2 And the role of the board was strengthened through

 3 the adoption of the requirement that the independent

 4 directors essentially had to nominate the other independent

 5 directors, to try to decrease the degree to which management

 6 had overreached the board, by threatening their tenure.

 7 Finally, the rule had -- as proposed -- had 

Page 32 
12b1transcript

 8 contained some factors. And not surprisingly -- this may

 9 come as a surprise to people, but sometimes regulators put

 10 things in rules that they expect to back off from, you know,

 11 to give the public something to chew on, an objective. The

 12 factors came out of the rule, because the -- and we will put

 13 into the release, as general guidance.

 14 The concerns the Commission expressed at that point

 15 was they did not want to constrict the business judgement of

 16 the board, and they did not want to provide a mechanical

 17 checklist for compliance, either.

 18 The other thing I would say about the factors is

 19 that they reflected the concerns at the time, in the sense

 20 that they talk about problems that might be addressed by a

 21 12b-1 fee. But they were clearly not regarded as a temporary

 22 fix. Instead, to say it one more time, it was a basic

 23 decision to let boards oversee a business judgement about how

 24 to use the fund's assets to promote distribution.

 25 MR. FINK: We have talked about some of the

 1 myths -- temporary, not just for dealers -- some of which

 2 seem to be promulgated by Matthew P. Fink in 2004, which I

 3 will have to go back and look at, but there is another thing

 4 I have heard. And that is not from directors on my board,

 5 that, "My goodness, we cannot make these decisions, because

 6 these factors do not fit."

 7 And my own reaction -- when I went back and

 8 researched this for a book I'm working on -- is the SEC

 9 didn't say you have to meet these factors. The rule

 10 expressly says these factors are suggestions, there may be 

Page 33 
12b1transcript

 11 others, "Use your business judgement." And the only

 12 decision, if I understand, that directors have to make,

 13 according to the rule, is, "There is a reasonable likelihood

 14 the plan will benefit the company, and its shareholders."

 15 So, the fact that you may be approving a plan that

 16 the purported or suggested factors don't fit, it's totally

 17 irrelevant. It seems to me, directors are paid a lot of

 18 money from directors. They're supposed to be educated,

 19 up-to-date, use their business judgement. And the fact that

 20 some of the possible factors don't fit doesn't hit me as a

 21 big obstacle.

 22 MR. GRANT: Well, obviously, boards have struggled

 23 with how to satisfy their duties, and they want to look to

 24 the guidance that the Commission has provided. I think, you

 25 know, a number of people have said it, I think it's certainly

 1 time to take a look, at the very least, at the kind of

 2 guidance they receive, and see if there is a way to give them

 3 a little bit more of a framework to help them with this.

 4 But nevertheless, you know, obviously, a huge

 5 number of shares are sold with 12b-1 fees, and that means

 6 that directors are finding a way to live with it. I think

 7 the more we can stress that -- at least some of the rules

 8 now -- it is a business judgement. And they bring that to

 9 boards, whether or not they bring specific expertise.

 10 They should look carefully at what the plan of the

 11 program is, to sell the fund's shares, and figure out whether

 12 it's working, and figure out whether it's practical to make

 13 changes, and if so, advise it. 

Page 34 
12b1transcript

 14 MR. SCHEIDT: Dick, was any serious consideration

 15 given to imposing a cap on the amount that funds could spend

 16 for distribution?

 17 You know, you talked about it in terms of business

 18 judgement, and that would reflect that there would be no cap. 

19 But if the expectation was that only a small amount of fund

 20 assets would be used for distribution, you think that the two

 21 could have worked together, and set a cap?

 22 MR. GRANT: No, I think that the Commission did

 23 stress that they would monitor the operation of the rule. In

 24 other words, they opened the door to allow people to use

 25 their imagination to come up with schemes, but planned

 1 to -- I mean that in --

2 MR. SCHEIDT: We don't like using the word

 3 "schemes" to describe --

4 (Laughter.)

 5 MR. GRANT: But they would continue to watch what

 6 was going on, and adjust as necessary.

 7 MR. GOLDBERG: I think, Doug, if you accept my

 8 theory, that it's really a chimera to say that mutual funds

 9 can't pay for distribution, it sounds great, but it doesn't

 10 work, that would be equally true of a cap -- if you said, you

 11 know, "You can't pay more than 25 points," or whatever figure

 12 you want to name, then you would come back to a latter day

 13 Mutual Liquid Assets saying, "Okay, the fund will pay 25

 14 points, and we're going to pay another 25 out of our advisory

 15 fee."

 16 Then you would have a latter day Banner Ready 

Page 35 
12b1transcript

 17 Resources saying, "We don't want to pretend we're paying it

 18 out of advisory fee, we're taking it out of the fund."

 19 So, I think a cap is the same as a prohibition,

 20 analytically. It's very hard to make it stick.

 21 MR. FINK: I will give you another example. 

22 Transfer agent, or omnibus account, I don't know, load funds,

 23 whatever we call them now, have a huge percentage, probably

 24 60 or 70 percent of their shares, held in omnibus accounts by

 25 brokers or 401(k) providers, who charge a fee per account.

 1 Now, are you paying that fee for record-keeping? 

2 Or, is part of it paying for distribution? Now what is that

 3 fee to Schwab or Merrill Lynch for?

 4 So, if you try to cabin it, and say, "No more than

 5 X for distribution," what do you do about your omnibus

 6 fee -- fee to your omnibus record keeper? What is that? I

 7 think these kind of categories just don't work.

 8 MR. SCHEIDT: Okay. So, the SEC adopted Rule 12b-1

 9 in 1980. What did the industry do next? How did -- how many

 10 funds quickly adopted 12b-1 plans, and what did they

 11 initially use fund assets for?

 12 MR. GRANT: I will let others to talk a little bit

 13 more about the development, but my own impression is that, at

 14 first, nobody used it. In fact, I think it was virtually a

 15 year before anybody adopted a 12b-1 plan, because I think

 16 that people really were quite concerned, you know, about what

 17 it meant, what would the SEC's attitude be towards these

 18 things? And, you know, what were the competitors going to

 19 do? 

Page 36 
12b1transcript

 20 So, it took a while before people were comfortable

 21 enough to take those first steps.

 22 MR. GOLDBERG: I think that's right. There was

 23 surprisingly little use of the rule in the early years. And

 24 it wasn't really until E.F. Hutton came in with its

 25 application for contingent deferred sales load, a company

 1 called "Hutton Investment Series," that was the first use of

 2 12b-1 in conjunction with a contingent deferred sales load. 

3 That sort of blew the lid off. But until then, there was

 4 very little interest in the rule.

 5 MR. FINK: Joel, can I -- a question, which I don't

 6 know the answer to this. Merrill Lynch had the big money

 7 market fund, Ready Assets.

 8 MR. GOLDBERG: Yes.

 9 MR. FINK: That had a 25 basis point trail for

 10 brokers. And what I don't know -- maybe Tom Smith, sitting

 11 there, will remember, or somebody else -- when that went on. 

12 And I don't know the answer to that.

 13 MR. GOLDBERG: It would have had to have been

 14 after --

15 MR. FINK: Why?

 16 MR. GOLDBERG: -- 12b-1.

 17 MR. FINK: Oh, yes. It would have to be after

 18 1980, but it may have happened before Hutton happened. Tom

 19 is nodding, so I think that -- so I think it's hard to

 20 collect that information, but my guess is that we may not

 21 know everybody. I think the brokers were putting on trails

 22 on their money funds. There were no-load money funds with 

Page 37 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 23 trails.

 24 MR. GRANT: There was a fair amount of controversy

 25 about that before the rule was adopted, because the view of 

the staff, at least, was that if you were prohibiting mutual 

fund payments for distribution, and if the adviser, or other 

third party, had a fee that it was splitting in some sense 

with sellers, wasn't that arrangement really a conduit for 

the use of the fund assets? 

So, both before and after adoption of the rule, the 

staff was frequently off pursuing a rumor that one broker or 

another was making these kinds of payments. And, of course, 

we never could find it. 

MR. SCHEIDT: It may have made sense, in the early 

1980s, when interest rates were really high, and money market 

funds were paying yields that were far higher than bank 

accounts, for funds to look to those high yielding accounts 

to be the first one to extract a small 25 basis-point fee. 

MR. FINK: I don't know if that's true, but it 

happened about that time. That's my recollection. 

MR. SCHEIDT: Equity funds were still in a slump 

from the 1970s, maybe starting to come out of it, but in a 

high inflationary environment, they may not have had the 

returns that would have made the imposition of 12b-1 

fees -- at least large ones -- palatable with investors. 

Well, Hamer Budget presaged the use of 12b-1 fees 

with the contingent preferred sales loads, but it was legally 

prohibited prior -- it was legally prohibited. And it 

required E.F. Hutton Investment Series to come in for an 

Page 38 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

exemptive order to allow funds to do what the insurance 

industry had done previously. 

So, Joel, can you describe those events, briefly? 

MR. GOLDBERG: Well, the precise prohibitions that 

would have prevented a contingent deferred sales load were 

somewhat unclear. I think Hutton recognized that this was a 

very aggressive and unusual use of 12b-1, so they filed an 

exemptive application under various sections of the Act. 

But there was nothing specifically prohibiting this 

type of arrangement. Essentially, what it involved was 

advancing a sales commission to the broker. And then, if the 

investor redeemed within the stated period -- let's say, six 

years -- they would have to pay a sales load on the way out. 

Otherwise, the fund would pay what, at the time, seemed like 

an extraordinarily high 12b-1 fee to recompense the 

distributor for having advanced the sales commission. 

Hutton's 12b-1 plan, I believe, was 100 points. I 

might be a little off on that, but -- and that was just way 

beyond what anyone had envisioned. 

I will confess that that application was issued by 

the staff under delegated authority without going to the 

Commission, should have gone to the Commission. The people 

processing it just didn't recognize its significance. 

We did recognize its significance after it was 

issued, and the final order was granted by the Commission. 

Page 39 
12b1transcript

 1 But I think it's unfortunate that the notice was issued

 2 without the Commission seeing it.

 3 MR. SCHEIDT: So, within two years of the adoption

 4 of Rule 12b-1, the brilliant minds in the industry had come

 5 up with a new way to use 12b-1 fees as a substitute for

 6 front-end sales load?

 7 MR. FINK: This is a little bit off, but I have to

 8 say this was the creation of one person who was -- I just

 9 want to give somebody credit here -- Gary Strum, who had been

 10 an attorney at Lord Abbott for years, left there to go to

 11 Hutton, and dreamt it up.

 12 And his boss at Lord Abbott, Ron Lynch, was a very

 13 good guy. And Lynch once said to me, "Strum was the

 14 brightest guy I ever had work for me. Thank God he left,

 15 because he would have bankrupted me." So that was quite

 16 an -- he was the one person who thought of this.

 17 MR. GOLDBERG: Well, one of the characteristics of

 18 contingent deferred sales loads -- and it caught some people

 19 in the industry by surprise -- is that the more shares you

 20 sold, the more money you lost.

 21 MR. FINK: Right.

 22 MR. GOLDBERG: Because the distributor had to

 23 advance the sales commission, and it would take years to get

 24 it back. And it's like the old joke that "I sell suits way

 25 below cost," you know, "How do you stay in business?" "I do

 1 it on volume." And many people in the industry discovered

 2 that about contingent deferred sales loads.

 3 MR. GRANT: So, the 12b-1 fee was used to pay the 

Page 40 
12b1transcript

 4 principal underwriter of the fund, who had advanced monies to

 5 the dealers who had sold fund shares.

 6 MR. GOLDBERG: Yes, that's correct, and it involved

 7 a little bit of a Procrustean application of 12b-1, because

 8 12b-1, as you know, says that the plan can continue, in

 9 effect, only if it's renewed annually by the board. And,

 10 even then, it can be terminated at any time by the board.

 11 So, every year, the board goes through this

 12 pretense -- I will use that word -- of, "Should we renew the

 13 plan?" Well, the distributor has advanced millions of

 14 dollars for contingent deferred sales loads. If the board

 15 said, "Gee, we have decided not to renew the plan, we're not

 16 going to pay you back this money," the distributor would be,

 17 shall we say, surprised.

 18 MR. GRANT: Of course, even a traditional A share,

 19 as they're sold now with a sales load in a 12b-1 plan, it's

 20 very difficult for a board to decide, "Well, we're going to

 21 discontinue it this year," because, of course, all those

 22 people who sold it originally are receiving those ongoing

 23 fees, and seeing themselves now as asset-gatherers. You stop

 24 paying them that fee, they're going to find another fund.

 25 MR. GOLDBERG: Yes, I think --

1 MR. GRANT: So, a zero-based revisiting of these

 2 fees is really not practical.

 3 MR. GOLDBERG: I think the notion that a 12b-1 plan

 4 is a year-to-year thing, and is redecided every year, is a

 5 little bit of fiction.

 6 MR. SCHEIDT: Well, that's true, when it's used as 

Page 41 
12b1transcript

 7 a substitute for front-end sales load.

 8 MR. GOLDBERG: Or, as Dick described, for a

 9 trial --

10 MR. SCHEIDT: Yes.

 11 MR. GOLDBERG: -- where the broker expects it to

 12 continue.

 13 MR. SCHEIDT: But it's not necessarily true, is it,

 14 when fund assets would be used for advertising expenses?

 15 MR. GOLDBERG: No, no. And that's what the

 16 Commission was anticipating. That's why the rule has these

 17 provisions, because they thought it would be advertising,

 18 training of sales people, that kind of thing.

 19 MR. GRANT: I think it is still a business decision

 20 that they can grapple with, it's just a question of being

 21 able to take a business-like approach to it, as opposed to

 22 sort of a theoretical or conceptual approach to it.

 23 MR. SCHEIDT: Okay. Let us forward a couple of

 24 more years and Kathie McGrath is on the scene in 1983.

 25 MS. MCGRATH: Yes. I came back to the Commission

 1 in the division of investment management in the summer of

 2 1983, and things were pretty quiet on the 12b-1 front, at

 3 least at first.

 4 But by 1985, some problems had begun to surface. 

5 The first thing I remember getting upset about was one fund

 6 group proudly went to a conference and explained to everyone

 7 how they had figured out a new method of boosting their

 8 performance yield by capitalizing on their 12b-1 fees,

 9 instead of expensing them. 

Page 42 
12b1transcript

 10 And so, we had to run off -- since they just

 11 explained to the entire industry how to do that -- and get

 12 the chief accountant's office to put a stop to it.

 13 But then, in the fall of 1985, I was presented with

 14 a memo by a division staff outlining what they referred to as

 15 the "use and abuse" of 12b-1, and proposing solutions, chief

 16 among which was a repeal of the rule, and going back to the

 17 idea of allowing advisers to use their advisory fees to pay

 18 for distribution.

 19 The end of 1985, there were about 600 funds with

 20 12b-1 fees. The amounts had gone up, in some cases, up to

 21 125 basis points. And they were being used to pay brokers'

 22 sales commissions up front, which, of course, the rule

 23 permitted, and were being combined with back-end loads.

 24 They weren't very well disclosed, and the press got

 25 onto the bandwagon, and there were numerous articles

 1 excoriating the fund industry, and the SEC staff for allowing

 2 these hidden loads. And then, the mail from Congress started

 3 arriving, and lots of small investors, surprisingly enough.

 4 One thing that got everybody riled up was the fact

 5 that funds who were charging these fees and using them to pay

 6 salesmen in, you know, amounts of 125 basis points, which

 7 pretty quickly got up to where sales loads were, were

 8 advertising themselves heavily as no-load funds. And the SEC

 9 said that Vanguard could do this, in an order, with its 25

 10 basis points. So we didn't think we could stop it. But we

 11 thought it was a problem.

 12 So, the SEC had promised, when it adopted the rule, 

Page 43 
12b1transcript

 13 to monitor it. So we decided we needed to take a look, and

 14 we did so through the disclosure office, which looks at

 15 prospectuses, and also the regional offices. And we found

 16 some things we didn't like. We thought they were problems;

 17 others didn't.

 18 One was, of course, the no-load advertising

 19 campaign. The second was on these 12b-1 fees that were

 20 paired with contingent deferred sales loads. The

 21 distributors were fronting an awful lot of money. And in

 22 order to get that paid back, the 12b-1 plans needed to go on

 23 for a long time.

 24 And they were also charging the funds interest,

 25 financing charges, which made it an even larger amount that

 1 would have to be paid back. And we thought this was

 2 inconsistent with what the Commission had laid out, which was

 3 these things had to be re-approved every year.

 4 And then, investors were not being told, in the

 5 prospectuses or anywhere else, about these finance charges

 6 and the sort of long-term nature of the 12b-1 plans. So, we

 7 also saw some situations in which these combinations of sales

 8 charges resulted in spectacular growth, but there weren't any

 9 break points or reductions in advisory fees coming as a

 10 result.

 11 And then, we saw another type of 12b-1 plan that we

 12 called a compensation plan, and that's basically where the

 13 fund board said, "Here is money we're going to give you. 

14 Take it, Mr. Distributor, and spend it how you please." But

 15 they really weren't required to return any unspent monies, 

Page 44 
12b1transcript

 16 and we had some problems with that.

 17 So, we did a couple of things, initially. We

 18 started asking for additional disclosure about how these

 19 finance charges worked, what amounts were being carried

 20 forward, how long a 12b-1 plan would have to go on in the

 21 prospectus, through the comment process.

 22 We saw some issues with how the 12b-1 fees were

 23 being used, where they collected from one series of a fund,

 24 and then use it to pay for distribution of a separate series. 

25 And we found some bad facts.

 1 In one case, where the distributor spent the money

 2 on, you know, dinner, flowers, a car wash, dry cleaning,

 3 chocolates, health club memberships, you know, and you sort

 4 of said, "Well, gee, a distributor must figure that a buff,

 5 well-fed guy in a neatly pressed suit must be able to sell

 6 more shares." But then we said, "Maybe they meant to bill it

 7 to the soft dollar account, and made a mistake."

 8 So, we looked at board records, to try to figure

 9 out what directors were being told. And in a number of

 10 instances, the specifics weren't there.

 11 We found plans that had lapsed, but the money kept

 12 on being paid, and some cases where they accrued and took

 13 from the funds 12b-1 fees, or deducted them from NAV, but

 14 never spent the money, and we had to go beat the fund up to

 15 get the money back.

 16 But we managed to put a stop to the use of the

 17 no-load advertising label with contingent deferred sales

 18 loads through a letter, but we still felt we weren't able to 

Page 45 
12b1transcript

 19 do anything on the fact that a fund had a very large 12b-1

 20 fee.

 21 We hit upon the idea of asking the NASD to take

 22 care of some of these concerns. It seemed inconsistent to us

 23 that the NASD would have these rules that said, "A front-end

 24 sales load in excess of this amount is excess of this amount

 25 is excessive, and brokers can't charge it," but not to have

 1 any governor at all on the amounts that could be collected

 2 through contingent deferred sales loads, or asset-based 12b-1

 3 fees.

 4 And also, the NASD was, at that point, taking over

 5 the review of fund advertising. So they seemed like a

 6 logical place to go. But we talked to them for a couple of

 7 years, and they insisted that they had no jurisdiction over

 8 anything but front-end loads.

 9 So, we went ahead with a fee table for the

 10 prospectus, which we thought would help investors get a

 11 handle on what they were paying in 12b-1 fees, and other

 12 costs of investing in a fund. And we kept getting pounded by

 13 the Congress and the press. I noted somewhere in a speech

 14 that we had gotten 65 inquiries from members of Congress on

 15 the subject, and I lost count of the press articles.

 16 After a while, the press actually did a lot of

 17 good. They increased investor awareness of 12b-1 fees, which

 18 was all to the better, and they had an effect on the use of

 19 the no-load label, because they would write nasty articles

 20 every time somebody did it. And, in fact, I found a

 21 prospectus in an old file from 1987, and this is what the 

Page 46 
12b1transcript

 22 fund started advertising. This was their new

 23 promotion -- the heat had gotten so bad -- "No 12b-1."

 24 So, in 1988, we gave up butting heads with the NASD

 25 over its jurisdiction, and put out our own rule proposal. 

1 And I remember that one of the first outlines of it that I

 2 got was titled by the division staff, "Seven Ways to Tighten

 3 the Screws," which should tell you what kind of a mood we

 4 were in at that point; it was not good.

 5 And it was more or less a failed proposal, but here

 6 is what we proposed to do. We said, "Unreimbursed

 7 distribution expenses going forward would have to be paid

 8 back within a year." This was sort of an effort to try to

 9 make sure the costs fell on, generally, the right group of

 10 shareholders.

 11 To deal with compensation plans, we said, "No, your

 12 plan has to spell out what you can spend the money for. And

 13 if you don't use it for those things, you've got to give it

 14 back to the fund."

 15 To deal with how much any one investor could be

 16 charged between 12b-1 fees, front-end/back-end loads, we

 17 basically cooked up something that said that in setting

 18 amounts of 12b-1 fees, the board needed to look at the NASD

 19 sales limits, and kind of figure what an investor would pay

 20 overall, and take that into account.

 21 We proposed annual shareholder approval of the

 22 plan -- that was the nastiest one -- and, of course, no more

 23 no-load labels.

 24 Well, in face of the seven screws, the NASD had a 

Page 47 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 25 miraculous change of heart about the scope of its 

jurisdiction. And a committee headed by Ron Lynch came over 

and asked if we could smoke the peace pipe, and if we would 

defer action on our rule proposal and let them take a crack 

at it. 

So, I talked to the chairman and a couple of the 

commissioners, and they said, "Okay," and they came back 

fairly promptly -- within a year -- with a proposal that got 

at most of what we were concerned about. But then it took 

them until 1983 to get it on the books -- 1993. I left in 

1990. 

So, they did put the brakes on it, to some extent. 

They kind of did a rough justice limit, so you had to take 

into account front-end loads, back-end loads, 12b-1 fees. 

They allowed 25 basis-point service fees to go on ad 

infinitum, not subject to the cap, and you know, by and 

large, they limited what funds could pay, rather than what an 

individual shareholder could be charged. 

So, it didn't perfectly resolve the concern that 

the money was falling on the wrong shareholders. But in 

those days, computer programs and accounting systems really 

were not up to trying to do something on a 

shareholder-by-shareholder basis. 

My two cents on all of this, you know, Americans 

like to pay on time. And most investors really don't know 

how long they're going to stay in a fund. So -- and one of 

Page 48 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

the reasons they buy mutual funds is because they know they 

can get out whenever they want. So, you know, I don't think 

front-end loads are the answer. People hate them. They also 

don't like deferred sales loads, because that causes them to 

feel they're stuck. 

So, it would be nice if something could be worked 

out to continue asset-based fees, if we can figure out how to 

clearly explain them to investors so they know what they're 

paying, and what they're getting. And we haven't gotten that 

right yet. Anyway, I left in 1990, so --

MR. SCHEIDT: Why were the other proposals 

failures? Did you get the sense that, by focusing attention 

on these issues, the industry responded, if there was concern 

about reimbursement plans, or about compensation plans, and 

your concern was that directors didn't pay enough attention? 

Did you get the sense that merely by focusing attention on 

those issues, directors paid more attention? 

MS. MCGRATH: No. I mean, I don't really think 

they -- everybody seemed to think I was crazy. I think what 

really had an impact was the financial press that came to be 

directed to individual investors. And they took up the 

cause, and they got a lot more attention. 

In fact, we found it very useful. It was a way of 

educating investors. "Money Magazine" was good at it, a lot 

of people read that. And it was a way to get the word out

that the SEC really couldn't -- they would follow what was 

Page 49 

 1 
12b1transcript

 2 going on with 12b-1 and write about it. It was a good thing.

 3 MR. SCHEIDT: You also mentioned that the computer

 4 systems at the time weren't sophisticated enough to

 5 individualize account treatment.

 6 I noticed, Matt -- and maybe you remember -- the

 7 ICI filed a statement in connection with a 1988 rule

 8 proposal, in which it raised the issue of imposing 12b-1-like

 9 fees at the shareholder account level, but argued that doing

 10 so would be operationally impractical, expensive, and

 11 burdensome. So there were some --

12 MR. FINK: We looked at it. And I just remember

 13 one large member thought that they could do it in a couple of

 14 years, and the others said they could not do it.

 15 MR. SCHEIDT: Okay. We're --

16 MS. MCGRATH: I think that was true, that the

 17 accounting systems at the time were just not up to doing it,

 18 across the industry. Either that, or they really fooled me.

 19 MR. SCHEIDT: Okay. We have come to the end of our

 20 historical perspective on Rule 12b-1, and this is the time

 21 when the individual panelists are invited to make brief

 22 personal remarks on their views -- who would like to start?

 23 MR. GOLDBERG: Let me say first what I think should

 24 not be done. I think an attempt to go back to prohibiting or

 25 limiting to a specific amount the bearing of distribution

 1 expenses by mutual funds is an imaginary line. It will

 2 survive only until somebody tests it. And we found that,

 3 historically, the evolution through Banner Ready Resources.

 4 So, the question is, "What should be done?" I 

Page 50 
12b1transcript

 5 personally would advocate bifurcating 12b-1 into two parts.

 6 One, where it's used as a substitute for a sales

 7 load, a contingent deferred sales load, a level load, I think

 8 there we should drop the pretense that the plan is a

 9 temporary thing that is in existence for only a year at a

 10 time, and is subject to termination. It's a contract. 

11 People have advanced money on the understanding it will be

 12 repaid. And, in fact, people are so sure it will be repaid,

 13 that the 12b-1 stream is sometimes used as security for a

 14 loan.

 15 Obviously, nobody believes the pretense that the

 16 board won't continue a 12b-1 plan in those circumstances. So

 17 let's call it what it is, a contractual obligation on the

 18 part of the fund to pay back a certain amount of money.

 19 Now, we might call the originally anticipated 12b-1

 20 plans advertising the type of expenses that can be terminated

 21 at will. There, I would keep 12b-1 in pretty much its

 22 present form. But the factors that Dick labored so hard to

 23 write in 1980, I think could use a serious updating.

 24 MR. FINK: Thanks. I will stick to the subject of

 25 this panel history, and not try to offer solutions. I must

 1 say I have come up with solutions that will satisfy the SEC,

 2 most importantly, the investors, the media, and the industry,

 3 but you will have to read my book on the history of the

 4 industry to get those.

 5 So, for now, I will stick with history. In the

 6 time -- I've been doing a lot of reading on history, and read

 7 a lot of books on the British Empire. And it has often been 

Page 51 
12b1transcript

 8 observed that the British Empire was created "in a fit of

 9 absent-mindedness." Some observers similarly maintain that

 10 the SEC somehow was absent-minded in 1980 when it authorized

 11 12b-1 plans, and didn't realize what it was giving creation

 12 to.

 13 Specifically -- and you read these observers

 14 -- they say the SEC thought that 12b-1 plans would be

 15 temporary, that they would be confined to the problem of net

 16 redemptions, that they would not be used to compensate

 17 dealers.

 18 Moreover, they claim that this absent-mindedness

 19 has continued over the last 27 years, and the SEC has never

 20 revisited the issue. And, finally, they say the SEC clearly

 21 wasn't focused, because it imposed impossible conditions on

 22 fund directors.

 23 But if you look at the historical record -- which

 24 I, frankly, was doing before these hearings this excellent

 25 roundtable was called -- all of these are not true. The

 1 record -- and you've heard from the two authors of the rule

 2 here, two principal authors -- the historical written record

 3 shows that the SEC did not assume that the plans would be

 4 temporary.

 5 The SEC did not assume that the plans would be

 6 restricted solely to address net redemptions. The SEC

 7 clearly contemplated, and expressly says in the rule that the

 8 fees would be used to compensate dealers. As a fund

 9 director, I can tell you that the SEC has not required

 10 directors to make virtually impossible findings. 

Page 52 
12b1transcript

 11 And, finally, you heard Kathie. The SEC has

 12 revisited the rule on a number of occasions. Obviously, the

 13 current Commission sitting here is free to retain, rescind,

 14 or change the rule. The Commission could decide that in 1980

 15 the SEC got it about right. Or, you could decide that the

 16 SEC in 1980 made some mistakes, which ought to be corrected. 

17 Or, you could decide that new conditions that prevailed today

 18 that didn't prevail then required changes in regulation.

 19 But whatever you do, I would ask that you base your

 20 decisions on the actual historical record, and not on myths

 21 that have developed. Thank you.

 22 MR. GRANT: I am not going to beat that horse any

 23 more, because we have all made the point. But I will say

 24 that the rule, of course, is not a substantive rule. It

 25 doesn't regulate the types or amounts of expenses that can be

 1 made. It's a procedural rule, that tries to tailor the

 2 process of considering distribution expenses with the other

 3 kinds of major decisions that boards have to make about the

 4 advisory contract, and the underwriting contract.

 5 I don't have a recommendation as to how the rule

 6 should be changed. It clearly -- at the very least, the

 7 guidance under the rule needs to be updated. I think

 8 everybody understands that.

 9 As for the rest of it, I would say, as I have said

 10 in the past, when people have wanted to change the rule, you

 11 know, just be sure not to make it worse.

 12 (Laughter.)

 13 MS. MCGRATH: Well, I think that the payment of 

Page 53 
12b1transcript

 14 fees by investors, either directly or indirectly, over the

 15 life of their investment is probably the best way to continue

 16 to go.

 17 Brokers and other intermediaries, you know, with

 18 whom we buy and hold and hold and hold fund shares provide us

 19 a lot of services. They do account statements and talk to

 20 us, they send us prospectuses, mailings, this, that, and the

 21 other. They deserve to be paid for that, that's a real

 22 service.

 23 And the problem is, you know, we haven't gotten the

 24 right way to explain it to investors, so they can understand

 25 it, the prospectus is not a very good point of sale

 1 disclosure mechanism. People don't need it, they don't read

 2 it, they don't even have to get it for five days after the

 3 sale. And that, I think, is where we have consistently

 4 failed. How do we make investors understand this?

 5 MR. SCHEIDT: Okay. Thank you very much. This

 6 concludes our first panel of the roundtable today. Thank

 7 you.

 8 (Applause.)

 9 CHAIRMAN COX: And on behalf of the commissioners,

 10 I just want to add my thanks. This was an outstanding

 11 presentation. We have the right people here to help us with

 12 the history, and we really will read your book in order to

 13 get the answers to this, one way or another.

 14 Thank you very, very much for your contribution,

 15 and we look forward to continue to hear from you, as we move

 16 forward on these important issues. 

Page 54 
12b1transcript

 17 (A brief recess was taken.)

 18 PANEL TWO -- CURRENT USES: THE ROLE OF 12B-1 PLANS

 19 IN CURRENT FUND DISTRIBUTION PRACTICES

 20 MR. PLAZE: Good morning, welcome to the second

 21 panel of today's roundtable on 12b-1. I am Bob Plaze, I am

 22 the associate director in the Division of Investment

 23 Management, and I would like to welcome you here, to the

 24 second panel.

 25 You have just heard a very interesting discussion

 1 on the historical perspective, what happened, and from whose

 2 perspective exactly what happened -- a couple of perspectives

 3 there.

 4 Similarly, there will be different perspectives

 5 offered in this panel of distinguished members of our

 6 investment company and regulatory community. This panel is

 7 on the current uses of Rule 12b-1, and current fund

 8 distribution practices. It's not the panel on how a 12b-1

 9 fund should be reformed, or changed, or rescinded, or

 10 amended. We're going to save that for the fourth panel, so

 11 we all keep your attention here today, while you eat your

 12 vegetables on this panel.

 13 Joining me on the panel is, alphabetically, Marty

 14 Byrne, Managing Director, the Office of General Counsel, from

 15 Merrill Lynch. Marty oversees the legal aspects of the

 16 investment advisory, investment company, and other investment

 17 management activities of Merrill Lynch's global private

 18 client business unit.

 19 Paul Haaga, here, is Vice Chairman of Capital 

Page 55 
12b1transcript

 20 Research and Management Company, as well as Chairman of the

 21 firm's executive committee. Paul is also an officer and

 22 director of several funds in the American Funds group, which

 23 is managed by Capital Research. With more than $1 trillion

 24 under management, it's one of our larger fund groups in the

 25 country.

 1 Mellody Hobson is President of Ariel Capital

 2 Management, a Chicago-based mutual fund company and

 3 investment management firm. Ariel Capital Management is the

 4 investment adviser to the Ariel Mutual Funds, which have more

 5 than $7 billion in assets under management. Although $7

 6 billion seems like a lot of money to most of us, in this

 7 group, Ariel Capital Management and Mellody is the

 8 representative of one of our smaller fund groups here, and

 9 will speak to the issues of 12b-1 to those small fund groups.

 10 John Morris is Senior Vice President, Asset

 11 Management Products and Services, at Charles Schwab &

 12 Company. In addition to its discount brokerage business,

 13 Schwab offers the OneSource program, the largest mutual fund

 14 supermarket, which allows investors to invest in a wide

 15 choice of mutual funds in a single account, and those

 16 services are intricately related to 12b-1 plans.

 17 Charlie Nelson is Senior Vice President of

 18 Great-West Retirement Services, a division of Great-West Life

 19 and Annuity Insurance Company. Among the largest 401(k)

 20 providers, Great-West provides retirement products and

 21 services. At the end of 2006, $1.5 trillion were invested in

 22 mutual funds through 401(k) plans, and they provide a 

Page 56 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 23 significant portion of the distribution of mutual funds in

 24 the United States.

 25 Tom Selman is Executive Vice President, Investment 

Companies Corporate Financing at NASD Regulation. NASD is an 

SRO of securities firms; it plays a very important role in 

12b-1 matters because it has adopted for its members rules 

that limit the distribution and services of mutual funds that 

brokers can sell, in addition to being responsible for mutual 

fund advertising, which was alluded to in the last panel. 

And, finally, but not last, Bob Uek is an 

independent trustee on the board of trustees of the MFS 

family of funds. MFS Funds, which include the first mutual 

fund in the United States, have over $120 billion of assets 

under management. 

Let's start right off here with the current model. 

Our Rule 12b-1 plans today typically work in conjunction with 

multiple classes issued by the same fund. I think there may 

have been some allusion to that in the first panel, but this 

is where we're going to dig into it, how it operates. 

Paul Haaga, could you describe, generally, some of 

the classes that are offered to retail investors, and the 

role 12b-1 plans play with each? 

MR. HAAGA: Sure. Thank you. And thank you very 

much for having me on the panel, Bob, and Commissioners, 

thank you. 

I have a hand-out, and I am not going to walk you 

through it, but I hope everybody has a copy of it. It gives, 

on one side, what the investor pays, either directly or 

Page 57 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

through the fund, and how they pay it. And then, on the 

other side, it has by whom the payment is received. 

But let me just talk generally about it. I can 

circle back and answer questions about specific fees and 

classes that are listed here. 

I think this roundtable would be greatly improved, 

the whole thing, if no one were allowed to say the word 

"12b-1 fees." Because every time it gets said, people think 

of different things. 12b-1 happens to be the rule. There 

are really three basic expenses, or fees, or bits of 

compensation that come out of 12b-1, and we really ought to 

separate them. And I hope someone will raise their hand, or 

say something if I use the word "12b-1 fees." 

There are -- the three kinds are -- ongoing service 

fees. Those are often 25 basis points in A shares. They are 

paid forever, they are excluded from the NASD maximum sales 

charge rule. They are 25 basis points on A shares. They're 

often higher on retirement shares, and you can see that from 

our piece here. 

The second is what I will call spread loads. Those 

are -- actually, they're a commission, they're 

transaction-based payments that happen to be spread out over 

time. They're paid on B, and to some extent, C shares. 

Think of them as the spread loads. Those are the ones that 

are financed by the 12b-1 plan. 

Page 58 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

I might add that when Kathie McGrath talked about 

1988 and all the problems, everything she talked about was B 

shares. It was all spread loads. She didn't say a word 

about the 25 basis-point ongoing service fees, and I think 

it's important to distinguish. 

And then, the last is the classic advertising 

expense, the one that Vanguard pioneered through their 

17(b)(3) order. But some other people have picked up it's a 

much smaller mark. 

The other thing I would like to say about it 

-- and it does relate to the types of classes -- is that I 

think our vocabulary traps us in thinking about this, what 

this is paying for, as being just something that takes place 

at the point of sale -- or I will call it the "opening of the 

account." But we have to devise a system that includes 

compensation for the entire relationship, the entire period 

of relationship, between the personal adviser or brokerdealer, and the investor. 

The up-front transaction opening of the account, 

initial purchase, is probably the least important time in 

that relationship. The most important, by far, is the end of 

the relationship, when -- or the back end of the 

relationship -- when the investor is taking money out of the 

fund, and seeking to do so without outliving their assets. 

That's when they need the most advice.

 1 And we have to have a system that pays for that. 

2 And, by the way, it's the one period when there are no more

 3 transactions. So if all of our compensation is based on 

Page 59 
12b1transcript

 4 transactions occurring, it's not going to happen, then there

 5 is going to be no motivation to keep that.

 6 Lastly, I heard someone refer in the first

 7 panel -- refer to the old argument, "Does it benefit existing

 8 shareholders to have more assets come into the fund?" You

 9 can debate both sides of that, but I don't think it's

 10 relevant here.

 11 I could concede to you that it doesn't benefit

 12 existing shareholders to have assets come into the fund. And

 13 I could still argue that a service fee payment to that

 14 person's adviser, and every other person's adviser, paid on

 15 an internalized basis, is a good thing to have, and it

 16 couldn't matter less how many assets are coming into the

 17 fund, or not coming into the fund.

 18 And finally, I just -- one other comment about the

 19 earlier panel. There were some negative comments about the

 20 role of directors in annually renewing the plan. And the

 21 underlying assumption there was that directors have two

 22 choices: continue the plan exactly as is; or terminate it

 23 completely. And that isn't what goes on in the renewal.

 24 There are many other choices, including: modify

 25 the plan; cut off sales of B shares and let the other ones

 1 roll off while paying the outstanding fees. That's a

 2 perfectly reasonable way to do it.

 3 I will just give you a couple examples of when

 4 modification has happened, even without cutting it off. The

 5 early B shares did not convert to A shares after a period of

 6 years. After several years of Merrill Lynch funds that had B 

Page 60 
12b1transcript

 7 shares, their directors observed -- the independent directors

 8 observed -- that they had been repaid for a lot of their

 9 up-front commissions, and said, "What next?"

 10 And from that was born the practice that is now

 11 universal, of converting into A shares, so that only the 25

 12 basis-point service fee would be paid by those investors

 13 after their early 1 percents.

 14 A very small part of our A-share 12b-1 -- a couple

 15 of basis points -- goes to pay commissions on very large

 16 accounts. They start at one percent, and drop below that for

 17 million dollar-plus accounts. In conversations with our

 18 directors, as those crept up over the years, we made several

 19 modifications, and removed most, but not all, of the

 20 recipients of those fees from the A share classes.

 21 We put them in -- our shares and others in

 22 quick-paying net transaction-based compensation. That was

 23 based on a conversation with directors, that was based on

 24 annual renewal. But it didn't involve the binary decision of

 25 keep it or cut it off. So I hope we will think a little more

 1 broadly and a little more nuanced about that.

 2 Let me stop there, and just refer everybody to the

 3 piece of paper.

 4 MR. PLAZE: Purchase a portfolio of, say, common

 5 stocks from a broker. I pay the broker a commission, the

 6 amount of which I am free, by law, to negotiate or accept

 7 their -- whichever broker I wish to.

 8 When I buy a portfolio of mutual fund shares, the

 9 way 12b-1 operates, I actually pay a sales load to the 

Page 61 
12b1transcript

 10 issuer, and then pay assets to the issuer, which are then

 11 directed back to the broker at amounts established by the

 12 fund. I have three payment programs -- class A shares;

 13 class B shares; class C shares.

 14 Why is this so different in the mutual fund

 15 industry than if you were buying common stocks? Which, I

 16 might add, you will need advice about in your dotage, also?

 17 MR. HAAGA: You are referring to the -- just to the

 18 transaction-based payments, not ongoing fees. It's

 19 operational, the reason that the brokers don't collect the

 20 sales charges, we collect them, is because we are actually

 21 maintaining the records and keeping the books. We're the

 22 only people who can collect them, particularly if there are

 23 follow-up payments for which a sales charge will be

 24 collected. That's why 22-D existed.

 25 Now, as -- over the years, it has happened that

 1 brokers have begun to maintain street name accounts that keep

 2 the accounts by name. They could start collecting the fees,

 3 the brokerage commissions. They haven't, but they could

 4 start collecting them.

 5 MR. PLAZE: Martin, could you -- we all know that

 6 funds pay 12b-1's and ultimately fund shareholders pay 12b-1

 7 fees, and they're disseminated through a distribution

 8 network. Can you explain how that works? I am particularly

 9 interested in how that affects net asset value, and then how

 10 the net distributions are made.

 11 MR. BYRNE: I guess let me step back just a minute,

 12 and just set out what I will assume are the usual 

Page 62 
12b1transcript

 13 arrangements.

 14 A fund usually enters into a distribution agreement

 15 with its principal underwriter, or fund distributor. Many

 16 times it's an affiliate of the management company. That

 17 company -- and that is the agreement and arrangement pursuant

 18 to which 12b-1's are paid. So they're paid from the fund to

 19 the principal underwriter. And then, typically, the

 20 principal underwriter will enter into arrangements with

 21 intermediaries who sell the funds.

 22 So, with that, I will go into how it actually

 23 works. Each day, the fund accountants will accrue the

 24 appropriate 12b-1 fee for the particular class, based on the

 25 NAV at the end of the day, to strike the NAV. Therefore, on

 1 a daily basis, the fund's NAV assumes that daily payment,

 2 because it's an accrued liability.

 3 Once a month -- well, let me step back. As an

 4 example, in a class A share, that would be 25 basis points

 5 accrued each day. And for a class B and C share, that would

 6 be 100 basis points accrued each day. Once a month, based on

 7 all those accruals, the fund will pay the fund distributor

 8 those amounts. And then, the fund, the principal

 9 underwriter, is responsible for paying the financial

 10 intermediaries.

 11 Now, what they will end up paying the financial

 12 intermediaries depends on the class. And starting with my

 13 previous example, for a class A share, they will usually pass

 14 along 25 basis points to the intermediary.

 15 In a class B share -- and we really didn't go into 

Page 63 
12b1transcript

 16 this -- there is usually an up-front payment to the broker. 

17 So, in a B share, the principal underwriter typically retains

 18 75 basis points of the 100, and passes along a 25 basis-point

 19 trail to the selling broker-dealer, or other intermediary.

 20 On a C share, because of the way a C share works,

 21 there is an up-front compensation to the broker of one

 22 percent for the first year of the -- since the initial

 23 purchase, the fund company, fund distributor, will retain the

 24 entire 100 basis points, because it up-fronted 1 percent to

 25 the financial intermediary. Thereafter, the payments will be

 1 one percent to the selling dealer.

 2 MR. PLAZE: What kind of investors are each of

 3 these classes designed to meet the needs of?

 4 MR. BYRNE: It depends what their preferences are,

 5 right?

 6 MR. PLAZE: Right.

 7 MR. BYRNE: As we heard from the previous panel, a

 8 lot of investors don't like to pay up-front loads,

 9 so -- because they don't know how long they're going to want

 10 to be in a fund. So, they will want to defer their payments

 11 of the service fees and distribution fees.

 12 Now, from an economic standpoint, A shares are

 13 probably best, economically, for folks who are going to

 14 purchase over $100,000 in an equity fund, or $50,000 in a

 15 fixed income fund for intermediate to longer periods of time,

 16 because of the break points. A B share --

17 MR. PLAZE: Could you explain the break points, for

 18 a moment? 

Page 64 
12b1transcript

 19 MR. BYRNE: Usually, there is a maximum front-end

 20 sales load, which could be, let's say, 5.25 percent. Based

 21 on if a person purchases certain levels, purchases in volume,

 22 they get a reduced sales load. So, often times, the first

 23 break point is either at $25,000 and $50,000.

 24 And if a person, on a cumulative basis, purchases

 25 up to that amount, their initial sales charge is reduced. So

 1 it will reduce in increments all the way to zero, typically

 2 at one million dollars.

 3 MR. PLAZE: So, a person eligible can actually be

 4 drawn to -- you have an economic interest in buying A shares. 

5 B shares people who want to avoid paying up front have their

 6 money go to work early. What role do C shares play?

 7 MR. BYRNE: One more thing. B shares are not only

 8 for people that want to defer. B shares could be

 9 economically better for someone who is buying lower amounts. 

10 So, the person who only wants $25,000, and has a long horizon

 11 because of the way B shares convert to As, they would often

 12 be better buying a B share, long term, than the A share.

 13 C shares, because of the compensation structure of

 14 one percent a year, are most economical for folks with

 15 relatively shorter -- short to intermediate -- time frames,

 16 and in amounts under one million.

 17 MR. PLAZE: How do investors figure out which of

 18 these three classes is in their interest?

 19 MR. BYRNE: Well, at a firm like ours they talk

 20 with their FA. We have tools to help them. The NASD has a

 21 tool to help investors considering their proposed holding 

Page 65 
12b1transcript

 22 period, their anticipated purchases, to try to come up with a

 23 class that is, price-wise, the most appropriate for them.

 24 MR. PLAZE: How do you deal with the issue when the

 25 financial advisor, the broker, has a different incentive

 1 structure to sell class A shares, or class B shares, instead

 2 of class A shares with a break point. How do you deal with

 3 this issue?

 4 This has been an issue -- a matter of a number of

 5 enforcement cases here, and at the NASD, over the years. And

 6 I know it's an issue troubling to brokers. It's a control

 7 issue with a brokerage firm.

 8 MR. BYRNE: Yes. Well, at our firm, we have limits

 9 and rules around -- ultimately, hard limits -- on what

 10 investors can purchase. So, for example, on the B share, we

 11 will hard block any purchase by a client that is -- on an

 12 aggregated basis, not a single purchase, but aggregated -- no

 13 more than $100,000 in an equity fund, in a fund family,

 14 $50,000 in a fixed income fund, and we don't permit purchases

 15 in B shares for low-duration funds.

 16 So, again, there is really no ability to purchase

 17 $90,000 and another $90,000, those would be aggregated, and

 18 it will be blocked.

 19 MR. PLAZE: Next, I would like to turn to another

 20 aspect of our panel this morning, to discuss the role 12b-1

 21 plans play in the business plans of different organizations

 22 that participate in the distribution of shares.

 23 I would like to go around the table, because we

 24 have here representatives of different organizations that 

Page 66 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 25 either pay, or receive, 12b-1 fees or provide various types 

of services to investors that invest in mutual funds. 

I would like to start off with representatives of 

load fund groups, perhaps start off with Mellody Hobson, from 

Ariel Capital Management. 

MS. HOBSON: I would start off by saying that, with 

$7 billion under management, as you said already, we are 

still a very small fund company, and maybe you would think of 

us as David versus Goliath, because you're used to hearing 

from all the big guys. But we are really the majority of 

mutual fund companies that are out there. The majority of 

funds are under $5 billion in assets. That is the starting 

point that I think is very important. 

Ninety percent of our assets, of Ariel Mutual 

Funds, come from third parties. And so that's another very 

important point to frame the discussion. We would argue we 

could not exist without the existence of the 12b-1 fee to 

grow the funds, ultimately. 

We would also argue that we believe the 

entrepreneurial spirit that has led to such a competitive 

marketplace in the mutual fund business would be very 

significantly affected, should 12b-1 fees not create an 

opportunity for small, entrepreneurial mutual fund companies 

to exist. 

There are four ways that 12b-1 fees are used within 

our firm. Specifically, we pay the financial advisors and 

Page 67 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

consultants who sell our funds. They may be selling direct 

as independent organizations, or they may be selling through 

the large brokerage firms. 

Secondly, we pay the supermarkets, the Schwabs and 

Fidelities of the world, that clearly offer the platform for 

the convenience of customers that like the combined 

statement. 

Thirdly, we pay the 401(k) plan administrators. 

Now, this has become an increasingly important part of our 

business, as defined benefit plans have gone away, more and 

more. 

And, specifically, it's the only reason, having 

that 12b-1 fee plan, that we can be in the plans at Wal-Mart 

and General Motors, alongside other gigantic mutual fund 

companies, like Fidelity and others. And we would argue 

that, really, the playing field is completely level when a 

small fund company, like Ariel, can be added at no cost to 

the plan or the participant, because 12b-1 exists, and can be 

passed on to help with the administrative costs. 

Last, but not least, we use our 12b-1 fee to offset 

our internal marketing costs, and those generally come from 

our direct shareholders, which, I remind you, is only 10 

percent of the shareholders that we have, in total. And so, 

that pays for our web site, it pays for the phone service 

that our shareholders get from any source that they may use,

to call and request information from Ariel. It pays for our 

Page 68 

 1 
12b1transcript

 2 marketing materials, it pays for our advertising.

 3 The one thing that we have heard people say is that

 4 this is a profit center for mutual fund companies. Well, the

 5 math does not suggest a profit center for us. We spend in

 6 excess of our 12b-1 fee each and every year.

 7 And to give you a sense of the magnitude of that

 8 spent, last year we spent $2.9 million in excess of our 12b-1

 9 fees on ongoing marketing, and marketing-related

 10 opportunities in order to grow the funds, which ultimately,

 11 of course, decreases their expense ratio for our

 12 shareholders.

 13 Lastly, I would just argue that once a fund is

 14 sold, we know, firsthand, that the work is not done, it is

 15 not over. And there is an ongoing relationship that has to

 16 be maintained. Either the financial consultant who is

 17 offering that ongoing advice; the supermarket that is

 18 providing that wonderful convenience and simplified

 19 statement; or firms like Ariel, ourselves, in dealing with

 20 the direct customer.

 21 And then, last but not least, since we know that

 22 four out of five mutual fund customers seek advice when

 23 buying a fund, I did want to add one nuance to this

 24 discussion I think that is largely missing on conversations

 25 about mutual fund and investing, and it's a result of

 1 actually pioneering research that Ariel has done with Charles

 2 Schwab and Company, where we have actually studied black

 3 investors for the last decade, when no one else has.

 4 And the one thing we know about black investors is 

Page 69 
12b1transcript

 5 they're more likely than even the majority population to seek

 6 advice, because we tend to be novice investors. And so, that

 7 advice component, and to be paying for that advice, we would

 8 suggest, is money actually very well spent.

 9 Last, but not least, in the context of my role as

 10 financial contributor on "ABC News," and weekly on-air person

 11 for "Good Morning, America," talking about the stock market

 12 and investing, I literally get hundreds of letters from

 13 investors on various topics. And I have said this before. I

 14 have never gotten a letter on a 12b-1 fee. But I have gotten

 15 a lot of letters saying, "There are so many choices out

 16 there. Help me understand, how do I decide?"

 17 And, again, I would go back to the fact that that's

 18 why that advice component is so important.

 19 MR. UEK: Without repeating a lot of the things

 20 that Mellody talked about, I think MFS, which is a little bit

 21 larger, in terms of its 40 Act fund business, is roughly $100

 22 billion. And in terms of what happens with all of its 12b-1,

 23 MFS is a load shop, and depends almost exclusively in terms

 24 of its distribution capabilities and strategies on 12b-1.

 25 And of the 12b-1 fees that it collects, something

 1 north of 95 percent of those are redistributed back through

 2 the intermediaries, whether they be brokerage houses, or

 3 independent financial consultants, or banks, or supermarket

 4 platforms, et cetera.

 5 Much like Mellody's comments, the 12b-1, or

 6 distribution capability or departments, if you will, of MFS

 7 are not a profit-making organization, either. When you add 

Page 70 
12b1transcript

 8 all the expenditures that they have, in addition to what they

 9 pay out to intermediaries, they pay out a substantial amount

 10 more money than what they take in, in 12b-1s. So it's not a

 11 profit-making entity, nor is it even near a break-even

 12 entity. The distribution costs are higher than the aggregate

 13 12b-1s collected annually.

 14 MR. PLAZE: That's interesting. The authors of the

 15 1940 Act were concerned about underwriters -- mutual fund

 16 underwriters -- being a profit center, inappropriate profit

 17 center. And yet, history has shown them to be a loss center,

 18 a loss in order to grow the assets of the fund, because the

 19 profits are from the advisory fees.

 20 MR. UEK: Well, I think if you stand back and look

 21 at the last, say, 10 or 15 years, the cash flows have

 22 migrated much stronger to the distribution end of the

 23 business.

 24 MR. PLAZE: Right.

 25 MR. UEK: And away from the manufacturing. And I

 1 think that's what is driving it, is to get your product sold. 

2 And I think Mellody made some very effective comments on

 3 that.

 4 To get your product sold is a very much more

 5 expensive proposition today. And whereas 12b-1 has been

 6 capped here for a number of years, and the cost of living

 7 doesn't get any less in general, and the distributors demand

 8 more, in terms of distributing the product, I think if we

 9 took a survey around most brand name load shops, we would

 10 find out that they were in a similar posture. 

Page 71 
12b1transcript

 11 MR. PLAZE: Mellody, the large fund shops, like MFS

 12 and Cap Research, can pay the same 12b-1 fees to brokers to

 13 sell their funds that you can.

 14 Does it -- at the end of the day, do you sense that

 15 it is a wash? That is, that Ariel Capital has to stand on

 16 the quality of its management services and its performance

 17 fees, because they're going to be able to match you, dollar

 18 for dollar, for a fee you're going to be able pay your

 19 broker. Or am I not getting something?

 20 MS. HOBSON: Obviously, scale makes a difference in

 21 any business. And so, if you're big, you can get

 22 preferential treatment, because in the case of the brokerage

 23 firms, they're obviously going to respond to MFS's call,

 24 probably, before they respond to mine, just based upon the

 25 actual revenues that we're both sending them.

 1 So, dollar for dollar, yes, we are paying the same

 2 amount. But in totality, the accumulated amounts are so much

 3 different, that it can make a difference. And, obviously, in

 4 the brokerage firms, scale also helps, in terms of brand name

 5 and name recognition, which ultimately leads to more sales.

 6 So, your goal, if you're Ariel, is to try to do

 7 your best to get as many financial consultants in a wire

 8 house to know you, so that, ultimately, you have the

 9 opportunity to have them sell your fund, and allow you to

 10 grow.

 11 But I wouldn't say, on a dollar for dollar basis,

 12 we are treated differently, with the exception of scale, if

 13 that makes any sense to you. 

Page 72 
12b1transcript

 14 MR. PLAZE: Well, my point is that a broker is

 15 going to receive the same amount of compensation, both now

 16 and over time, from selling two fund groups. The

 17 differential won't be the amount of compensation, it will be,

 18 perhaps, the quality of the management services.

 19 MS. HOBSON: The quality of the management

 20 services, and the quality of the job that we do, in keeping

 21 that broker abreast of who we are, and what we do.

 22 And so, if you have $7 billion under management,

 23 and you have to market to Merrill Lynch, and they have

 24 thousands of financial consultants, it's going to be harder

 25 to do that for us, than it will be for a mutual fund company

 1 that has $200 billion under management that, literally, will

 2 just have more people on the ground.

 3 MR. PLAZE: And let's hear from the man with real

 4 scale to talk about, Paul Haaga from Cap Research.

 5 MR. HAAGA: Well, yes. I'm having trouble with

 6 what the question is, but you know, on just the follow-up you

 7 had with Mellody, we have had the same pricing and

 8 compensation structure for the last number of years.

 9 In the late 1990s, we couldn't give our funds away,

 10 because everybody was buying tech stocks and tech funds, and

 11 Internet funds, and we didn't have those. And then things

 12 turned around for us after the market crashed. And, happily,

 13 they have stayed good.

 14 So, I would suggest that the amount paid is

 15 relevant, but it's hardly determinative. And when brokers

 16 come to us and talk about why they use our funds with their 

Page 73 
12b1transcript

 17 clients -- and notice that vocab, right, they don't "sell"

 18 our funds, they "use" them with our clients, or advise their

 19 clients about investing in them throughout their lives -- the

 20 first thing they say is, "We have never had to apologize for

 21 you." And I think that's important to them, too.

 22 So, we all think in terms of distribution channels,

 23 and products, and things like that. And we ought to think

 24 about relationships between the personal advisers, and

 25 brokers, and their clients, as they're trying to have a

 1 long-term relationship too, not just peddle stuff.

 2 MR. PLAZE: Let's move on to the broker-dealers,

 3 the first large -- perhaps the largest distribution part of

 4 the business.

 5 Marty, if you would, explain to me how 12b-1 fees

 6 are used and how they're integrated into the distribution

 7 network for brokers.

 8 MR. BYRNE: Sure. Like many of our other broker9 dealer competitors, we provide our customers with a lot of

 10 choice, what mutual funds are available to them. So we have

 11 approximately 125 or so fund families, and over 3,500

 12 individual funds, and probably more than 14,000 share classes

 13 available to our clients.

 14 And our financial advisors are compensated, based

 15 on the same formula for all the funds, so there are no

 16 significant, if any, incentives to pick one fund over

 17 another. So they're really competing on the quality of the

 18 management and service they're provided by the fund

 19 companies. Our financial advisors work with our clients to 

Page 74 
12b1transcript

 20 help them select the right -- the appropriate funds for them,

 21 and to monitor them over time.

 22 To do that, it takes substantial infrastructure,

 23 information, materials, tools, and other resources to support

 24 the information flow regarding all of these different funds

 25 and different share classes.

 1 So, the 12b-1s in our firm are used, in part, to

 2 compensate our financial advisors for their efforts with

 3 clients, and to support the infrastructure, to allow both FAs

 4 and clients to know and understand the funds. And I can give

 5 you a few examples of things that we have available to

 6 clients and FAs.

 7 MR. PLAZE: Well, let me turn to a slightly

 8 different direction here, if I can. The principal way

 9 Merrill Lynch is compensated from the fund groups is either

 10 from the collection of the sales load, or the stream of the

 11 12b-1 fees from the fund companies. That's the principal --

12 MR. BYRNE: That's the combination.

 13 MR. PLAZE: Combination.

 14 MR. BYRNE: Right.

 15 MR. PLAZE: That's the principal combination. But

 16 there are other platforms available at Merrill Lynch in which

 17 mutual funds are sold at net asset value, am I correct?

 18 MR. BYRNE: Yes.

 19 MR. PLAZE: Without fees --

20 MR. BYRNE: Correct.

 21 MR. PLAZE: So, in one case, there is -- the

 22 distribution system controlled by the mutual fund companies, 

Page 75 
12b1transcript

 23 and the structure of the sales load to the 12b-1 fee. But

 24 there are other platforms you have that sit side by side.

 25 Could you explain some of those? Because I think

 1 they're interesting, because operationally, there is another

 2 kind of distribution that people may not be nearly as

 3 familiar with.

 4 MR. BYRNE: Are you referring to the --

5 MR. PLAZE: The programs were all distribution I

 6 presume -- what kind of shares are sold to wrap fee programs?

 7 MR. BYRNE: Yes. Typically, A shares

 8 load-waived --

9 MR. PLAZE: Load-waived --

10 MR. BYRNE: -- with the wrap programs, and that is

 11 consistent with the fund prospectuses that we would require a

 12 fund to sell in one of our wrap programs, a fee waiver for

 13 the shares sold in that program.

 14 MR. PLAZE: And similarly, with the fee-based

 15 accounts, which, of course, are at issue now.

 16 MR. BYRNE: Correct. Right. So they are sold

 17 through -- right. Our fee-based brokerage account has a mix

 18 of individual securities, as well as funds in some of the

 19 client accounts.

 20 MR. PLAZE: They won't pay a sales load and they

 21 won't generally pay a 12b-1 fee, either, will they?

 22 MR. BYRNE: Well, it depends. Whether they pay a

 23 12b-1 fee depends on the share class made available by the

 24 fund's prospectus. So, if the prospectus makes A shares with

 25 the 12b-1 available through the program, then it will be A 

Page 76 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

shares that will be sold. In certain cases, the fund 

families will make I shares, or pure no-load funds available, 

and those would be the ones. 

We have a policy at Merrill Lynch always to choose 

for those programs the lowest expense share class that is 

available by the fund's prospectus for that program. 

MR. PLAZE: So, in those platforms, in that 

context, the distribution expense is all pretty much paid at 

the account level, by the wrap fee, or whatever the fee is, 

the fee-based brokerage -- the principal. 

MR. BYRNE: Well, the client doesn't --

MR. PLAZE: Right.

MR. BYRNE: The client does pay a portion of it,

yes. 

MR. PLAZE: Right. Now, you also sell ETFs, 

correct? 

MR. BYRNE: Yes. 

MR. PLAZE: And ETFs, they pay a brokerage 

commission. So the distribution component of an ETF 

transaction is paid at the brokerage account level, not by 

the fund. 

MR. BYRNE: In a fee-based program, or --

MR. PLAZE: Any program. 

MR. BYRNE: Well, in a fee-based program, they 

wouldn't be paying a commission. 

Page 77 
12b1transcript

 1 MR. PLAZE: Right, right.

 2 MR. BYRNE: They would be paying, you know, the

 3 fee-based --

4 MR. PLAZE: But even in a commission-based

 5 program --

6 MR. BYRNE: In a commission-based account, they

 7 would pay a commission on the purchase --

8 MR. PLAZE: Right.

 9 MR. BYRNE: -- as well as the sale.

 10 MR. PLAZE: Okay.

 11 MR. BYRNE: Which is important, because in a mutual

 12 fund --

13 MR. PLAZE: Right.

 14 MR. BYRNE: -- you know, if you buy an A share, you

 15 only pay on the purchase.

 16 MR. PLAZE: Right.

 17 MR. BYRNE: Not on the sale. So there is a

 18 difference.

 19 MR. PLAZE: It's a --

20 MR. BYRNE: And something to note is -- which a lot

 21 of our clients, like particular fund families, if they do a

 22 one-time purchase into a fund family and pay an up-front

 23 load, they can, for 20 years, buy and sell funds within that

 24 fund, within that family, with no transaction fees at all.

 25 So, if you were to do that with ETFS, economically

 1 you would be far, far behind where you would be with a mutual

 2 fund. It depends on the client, what they want, and what

 3 they choose to do. 

Page 78 
12b1transcript

 4 MR. PLAZE: Okay. Let's move on to retirement

 5 plans. Charlie Nelson, representing a larger retirement plan

 6 company, explain the role of 12b-1 revenues in financing

 7 these plans.

 8 MR. NELSON: Sure. Thank you. To really

 9 understand the context of how 12b-1 fees and other fees are

 10 receiving inside of a retirement plan, I am going to kind of

 11 set the context of the retirement market. Because it's not

 12 just kind of a uniform approach over all plan sizes.

 13 I do have a chart, and it will be on the SEC web

 14 site -- but I think they will put the first one up here on

 15 the graphics -- that really shows the size segments of the

 16 401(k) market that looks at, from microbe, all the way up to

 17 the mega-size.

 18 About 96 percent of plan sponsors are represented

 19 in the small to micro side of the 401(k) market. Now, they

 20 represent only about a third of the participants. The

 21 products that are used in each one of these segments in the

 22 401(k) market really do differ an awful lot by the size of

 23 the plan sponsor.

 24 I think the next point that is important to put in

 25 context is the revenue that a record-keeper receives from a

 1 mutual fund, which really, I think to Paul's point, comes in

 2 two kinds of categories. We refer to it as shareholder

 3 service fees, and then 12b-1 fees.

 4 Shareholder services and fees are for ongoing

 5 services provided for the retirement plan and the

 6 participants, and the record-keeping in the program. And 

Page 79 
12b1transcript

 7 that's about a 50/50 mix, for a retirement record-keeper, on

 8 average.

 9 So, if you then take the next step, and say, all

 10 right, you look at advisers, brokers, advisers that

 11 distribute and provide services to participants and plan

 12 sponsors, they provide a wide range of services to plan

 13 sponsors and participants.

 14 But about two-thirds -- almost two-thirds; 62

 15 percent of them -- mainly receive their compensation through

 16 a commission, or 12b-1-type fees, one or the other type of a

 17 concept. These are not one-time sources of compensation,

 18 they're really an ongoing source of compensation. And it

 19 rewards and recognizes an adviser's time for any education,

 20 communication, enrollment services, a wide range of services

 21 they will provide, both to the participant, as well as at the

 22 plan level.

 23 So, with this kind of framework around it, you kind

 24 of then start to go into the types of products that are

 25 offered in a 401(k) plan.

 1 Probably at the small to micro end, we would talk

 2 about bundled programs, or bundled products. This is

 3 generally where you have one record-keeper that provides all

 4 the statements and the Internet site, and all the trading for

 5 participants and plan sponsors. And that provider would

 6 then, essentially, collect all the 12b-1s. And that,

 7 actually, in terms of their total revenue for a

 8 record-keeper, is generally around 15 percent of the total

 9 revenues that are required to run a retirement plan. So it's 

Page 80 
12b1transcript

 10 only 15 percent of the total.

 11 But out of that total, the bundled record-keeper,

 12 or the provider, would then pay the broker-dealer, who would

 13 then pay an adviser compensation for their services, which

 14 are generally around, again, enrollment communication and

 15 education and participants providing investment guidance to

 16 the plan sponsor. Very important and valuable services, both

 17 to a plan sponsor, as well as a participant.

 18 You then move up maybe to what you might think of

 19 as a mid-market, or a mid-size plan, they often utilize

 20 products that are called semi-bundled. In a semi-bundled

 21 product, again, you would have one record-keeper, but you

 22 would also have an adviser or a broker, and potentially a

 23 third-party administrator, who would be providing various

 24 types of services.

 25 Again, the third-party administrator and the

 1 adviser-broker are really being contracted by the plan

 2 sponsor to provide services to their participants in the

 3 program.

 4 Now, in those situations, most often a 12b-1

 5 compensation is paid to the broker-dealer, and then paid

 6 directly to the adviser-broker, or third-party administrator. 

7 So the record-keeper in the retirement plan is not really a

 8 part of that transaction, it's more of a transaction between

 9 the plan sponsor, if you will, hiring the broker-adviser, and

 10 then the mutual fund company paying the corresponding

 11 compensation.

 12 The last type of product is a little bit more rare 

Page 81 
12b1transcript

 13 in some ways, in that it's only used by the large plans. And

 14 not all large plans use this, because it's a very expensive

 15 way, and complex way, to provide services. And this is

 16 really in what we will call the unbundled world, the

 17 unbundled record-keeping situation.

 18 And this is where a plan sponsor, a large or a

 19 mega-plan, would hire a record-keeper for their 401(k), or

 20 457, 403(b) plan, whatever, and provide the services.

 21 But then, the plan sponsor will go out and hire all

 22 the other vendors that are needed for services, maybe someone

 23 to create communication materials, someone to do enrollment

 24 meetings, someone to provide plan design and consulting

 25 services, all the different kind of vendors that are needed

 1 to support a retirement plan.

 2 Now, with that, the plan sponsor will also direct

 3 the record-keeper, who will then collect all the 12b-1 fees

 4 and shareholder services fees, to pay the various vendors

 5 their fees for providing the services to the plan's

 6 participants. It's really kind of more the open concept, if

 7 you will.

 8 MR. PLAZE: Charlie, why -- it strikes some as odd,

 9 and there is a reason for it, do the plan participants not

 10 pay the fees? Why is it cycled up through the fund and comes

 11 from fund payments, from out a 12b-1 fee, in sort of the

 12 bundled world, as you described it?

 13 In an unbundled world, wouldn't the actual cost of

 14 the plan be more apparent to the participants?

 15 MR. NELSON: Well, first, the plan sponsor is the 

Page 82 
12b1transcript

 16 entity -- or is the organization, if you will -- that

 17 dictates how the fees, and which products, are actually

 18 purchased.

 19 Now, there tend to be some general themes, by

 20 market segment size, of the types of products that are

 21 purchased by plan sponsors. So plan sponsors are really the

 22 ones, in a lot of ways, that dictate, "All right, I'm going

 23 to purchase a bundled product, or an unbundled product, or a

 24 semi-bundled." And there are certain economic situations

 25 that might make them more attractive in different size

 1 segments.

 2 MR. PLAZE: So, a plan sponsor would have an

 3 incentive to choose a fund group to manage its 401(k) that

 4 provided the funding for those services, rather than the one

 5 that simply, say, provided a lower level of expenses.

 6 MR. NELSON: Well, plan sponsors have a fiduciary

 7 responsibility to look out after -- obviously, over the plan. 

8 I think we all are aware of that. And so, they have to look

 9 at the whole context of the program, the services, balance

 10 out the services, balance out all the revenues and the

 11 expenses that are required to run that plan, to provide those

 12 services.

 13 So I think when you look at it in total, and in

 14 concept, they have the fiduciary responsibility, and I

 15 believe because the expenses are then disclosed, in 5500s

 16 back to the plan sponsor and ultimately made available to

 17 participants, if they choose, they are disclosed to a

 18 participant. 

Page 83 
12b1transcript

 19 MR. PLAZE: But as a plan administrator, whether

 20 the fund pays or whether the account pays is not important to

 21 you, it's not significant to you.

 22 MR. MORRIS: No.

 23 MR. PLAZE: We have another very important segment

 24 of this issue, which is the fund supermarket, which Mellody

 25 and Paul alluded to earlier. We have a representative of

 1 Schwab, Mr. Morris. Good morning. Tell us a little bit

 2 about the supermarket, what it does, and how the supermarket

 3 is financed.

 4 MR. MORRIS: Sure. Thanks, Bob. And, yes, 12b-1

 5 fees are often used by funds to pay fees to fund supermarkets

 6 for the various services they provide, and I will provide

 7 some context about the various types of services that a

 8 supermarket, like Schwab, does provide.

 9 Funds have long been at the core of Schwab's

 10 business. We started the first supermarket to focus on

 11 no-load funds, and that was over 20 years ago. And in 1992,

 12 we launched Mutual Fund OneSource, which was the first

 13 no-load and no transaction fee fund supermarket.

 14 Today, clients can choose from over 4,000 mutual

 15 funds, from 450 different families, 4.2 million Schwab

 16 accounts hold funds with $445 billion in assets.

 17 We believe strongly that few innovations have had

 18 as significant a benefit to investors as supermarkets. They

 19 have democratized mutual fund investing by increasing the

 20 choices available to investors, and provide the

 21 infrastructure for, literally, thousands of funds to become 

Page 84 
12b1transcript

 22 successful. And I emphasize some of the smaller funds that

 23 Mellody was mentioning earlier.

 24 We help keep costs down. You know, when you look

 25 at the competition that was brought about by supermarkets,

 1 it's critical for a fund to keep their expenses as low as

 2 possible, especially in light of the fact that investors can

 3 easily compare the expenses and other aspects of funds in

 4 order to make better informed decisions.

 5 Certainly, supermarkets have made investing simple. 

6 If you look back, I think many of us can recall back before

 7 supermarkets, if you wanted to buy a fund, that may be one

 8 thing if you're self-directed. If you wanted to buy a number

 9 of funds, that became a little more complicated. You would

 10 send your check in and maybe an application to a fund.

 11 And then, of course, if you wanted to switch among

 12 funds, that's when things really got interesting. You would

 13 have to send in your redemption to the one fund, wait for the

 14 proceeds, take those proceeds, and then send it off to the

 15 next fund, and all this time being out of the market. So

 16 that was pretty time consuming and cumbersome and

 17 inconvenient. And, of course, with supermarkets, this

 18 painstaking process is a thing of the past.

 19 So, in terms of the services that we provide to

 20 individuals and mutual funds companies, these are services

 21 that the funds would otherwise have to provide themselves. 

22 What we do is: we execute and settle fund transactions; we

 23 distribute dividends; prepare trade confirmations and account

 24 statements; we send fund prospectuses, annual reports and 

Page 85 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 25 other communications; we maintain branches and call centers, 

most of which are staffed 24 hours a day, 7 days a week, all 

to support the investor. 

We also have a state-of-the-art web site that 

provides a broad array of resources, tools, and information 

that investors can use to easily compare funds, based on 

their own needs and priorities. 

And then, finally, to the fund we offer a variety 

of record-keeping and other administrative services. It 

benefits from savings on transfer agent costs -- the fund 

does -- from the scale of omnibus cost savings. 

For example, we aggregate all the trades that we 

get each day for a fund, and place that aggregate -- place it 

as a single purchase and single redemption, so the fund 

receives a single order, as opposed to thousands. 

MR. PLAZE: I am interested in a couple of your 

statements. One, your interest in keeping fund expenses low, 

which I think everybody does, particularly directors. The 

Schwab plan charges 40 basis points for a fund to 

participate. Now, the average expense ratio of an equity 

fund in the United States is 81 basis points. 

So, we're talking about a significant expense 

there. Who pays that fee? 

MR. MORRIS: Well, various arrangements. I was 

going to get to --

MR. PLAZE: Oh, I am very sorry. 

Page 86 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

MR. MORRIS: I will do that now. In OneSource, the 

payment to Schwab is 40 basis points, typically. And they 

can -- the fund can use -- they can choose to use part of the 

12b-1 to pay for part of that. They can use a shareholder 

servicing plan from the fund, or from the affiliates -- the 

legitimate profits of the affiliate. 

I think if you look at it in terms of the fee, 

we're in a competitive marketplace. And I don't think 

anybody would pay us a dime if there weren't -- if there 

wasn't value received for those services that we're 

providing. 

And I think that in terms of the scope, and the 

services, the quality of the innovation that we provide, 

we're market leading. You know, you just look at the call 

centers, the 24-hour access, the web site we provide to 

investors, the support to investors, what we provide to the 

fund companies, as well. For example, in 2003 we introduced 

something called the STAP, the Schwab Trade Activity Portal, 

which allows funds to look into the omnibus account, and see 

the trading activity on a real-time basis. Those are the 

types of benefits that we provide. I think the 40 basis 

points reflects that. 

MR. PLAZE: When Schwab started, it was basically a 

transaction fee, so that investors paid when they used the 

services. And then you moved, I believe, in 1984, 1985, to

an asset-based model, so that transactions are essentially 

Page 87 

 1 
12b1transcript

 2 free.

 3 MR. MORRIS: Well, what --

4 MR. PLAZE: Why did you make that move?

 5 MR. MORRIS: Right. So, as I alluded to, we first

 6 started the no-load marketplace back in the mid-1980s --

7 MR. PLAZE: Right.

 8 MR. MORRIS: -- and there, the clients enjoyed all

 9 the conveniences I mentioned. But they didn't pay a

 10 transaction fee, they paid a ticket charge, or a fee when

 11 they purchased and when they redeemed the fund.

 12 And our chairman, Chuck Schwab, always implores us

 13 to listen carefully to clients. Clients were saying, "This

 14 is a convenient service, but this transaction fee is not so

 15 convenient." And we then looked at, okay, we're providing

 16 these services for the funds. Is there some way that we

 17 could remove the transaction fee that the client pays, and be

 18 compensated by the funds for the services that we provide?

 19 And, of course, what that does is give the

 20 individual investor great choice. They can choose to select

 21 funds with transaction fees or without transaction fees. A

 22 lot of our smaller investors love no-loads and no transaction

 23 fees. It's kind of in their DNA.

 24 So, that's been born out by -- just after we

 25 started OneSource, there were about a million positions in

 1 OneSource, and now there are over nine-and-a-half million

 2 positions. So I think that clients just -- a key is choice,

 3 they can have that choice. But as I said, many prefer no

 4 loads with no transaction fees. 

Page 88 
12b1transcript

 5 MR. PLAZE: Ms. Hobson?

 6 MS. HOBSON: Yes. I just wanted to add, I know you

 7 didn't ask me the question, but it's such an important source

 8 of assets for us -- we've got about $1 billion with

 9 Schwab -- I want to make the point that we've been able to

 10 demonstrate -- and we have to, at our board meetings -- that

 11 our mutual fund investors are not in any way disadvantaged by

 12 going through Schwab, versus going direct to Ariel.

 13 So, even though it's 40 basis points that we're

 14 paying, the 25 basis point 12b-1 fee would be paid,

 15 regardless. So that's first and foremost.

 16 Then, the 15 basis points that is the difference

 17 comes out of what we call the sub-TA fee. So basically, what

 18 we say is, if this account had been on our system at Ariel,

 19 all these thousands, hundreds of thousands of accounts that

 20 we have with Schwab, what would it have cost us to maintain

 21 them ourselves? What our trustees tell us is we can't pay

 22 any more than what we would pay ourselves.

 23 And so, it runs us about 15 basis points to service

 24 our shareholders. So, at the end of the day, because Schwab

 25 is one omnibus account for us, our funds are actually

 1 advantaged by having that billion dollars in one account, as

 2 opposed to being spread out over hundreds of thousands of

 3 accounts, so it drives the expense ratio down for us, on an

 4 overall basis, and at the same time is a net flat effect to

 5 all shareholders of the fund.

 6 MR. PLAZE: So you have a very large percentage,

 7 you're suggesting, of your shareholders who have come in 

Page 89 
12b1transcript

 8 through the Schwab plan.

 9 But the 40 basis points applies, across the board,

 10 regardless of whether a particular shareholder's assets have

 11 come in through that plan, am I correct?

 12 MS. HOBSON: That's actually the point I am trying

 13 to make. So just to run the fund, to send out a statement to

 14 a shareholder that comes to Ariel Capital, to send them a

 15 prospectus every year, and all the other things, to price the

 16 fund, all those things, there is about a 15 basis-point

 17 charge, if you were to look inside the expense ratio, that an

 18 Ariel mutual fund direct shareholder would pay.

 19 Schwab does that for us in this scenario, so we

 20 just pay them to do it for us.

 21 MR. PLAZE: Okay. Let's move on to shareholder

 22 servicing, which is something we have touched upon here, but

 23 let's deal with it perhaps more directly, and have some

 24 comments from some different panelists.

 25 According to the ICI, 52 percent of 12b-1 payments

 1 are used to pay ongoing shareholder services. Yet they are

 2 paid pursuant to 12b-1 plans. Shareholder servicing expenses

 3 are not necessarily a distribution expense. One might think

 4 that they would not otherwise be paid through a 12b-1 plan.

 5 The NASD has struggled over this in its rules. 

6 What is the distinction between shareholder services and

 7 distribution, and what do you make of the fact that this is

 8 paid pursuant to a 12b-1 plan? The 15 basis points

 9 subaccounting fee is not paid pursuant to a 12b-1 plan, of

 10 course. 

Page 90 
12b1transcript

 11 MR. SELMAN: Okay. First of all, I would like to

 12 thank the Chairman and the Commissioners for inviting me to

 13 participate on this roundtable.

 14 I did discuss with some of our broker-dealer

 15 members what this service fee is being used for, and I did

 16 hear from some of our broker-dealers, especially the smaller

 17 NASD members. And I have a brief list that I would like to

 18 go through, because I thought it was fairly instructive.

 19 Some of our members said, for example, that the

 20 service fee -- and this is the part of the 12b-1 payments

 21 that doesn't have to do with the transaction itself, nor does

 22 it have to do with the record-keeping type activities that

 23 brokers do.

 24 Those services would include: reassuring customers

 25 during declining markets, which was particularly important in

 1 the last few years; assisting customers in rebalancing their

 2 portfolios; reviewing customer holdings on a regular basis;

 3 reassessing customer needs and investment strategies;

 4 assisting customers with lost dividend checks and

 5 certificates; assisting inactive customers; answering tax

 6 questions, at least that the broker is able to answer;

 7 answering other questions from customers; and helping

 8 investors just generally understand their investments.

 9 Moreover, if you look at some dealer agreements

 10 with mutual fund companies, you will see that, in some cases,

 11 mutual fund companies will require the dealers in the dealer

 12 agreements to make regular contact with customers, to ensure

 13 that the customers are getting the level of service that the 

Page 91 
12b1transcript

 14 mutual fund companies expect them to get.

 15 Now, I will say, of course, the NASD regulates, we

 16 cap, both the asset-based fees -- which are really the

 17 distribution part of 12b-1 fees -- and the service fees. And

 18 I guess I'm here to confess that maintaining price controls

 19 is not a very easy thing for a regulator to do, and I

 20 wouldn't recommend that any regulator do it.

 21 It is very difficult, as a practical matter, to

 22 decide whether somebody is incurring a fee for services,

 23 versus distribution. Let me give you just one example.

 24 If you have a customer who is getting nervous about

 25 a particular mutual fund that the customer owns, and that

 1 customer goes to the broker and says, "I would just generally

 2 like to know some information about how redemption would

 3 work. What would happen if I redeem these shares?" And the

 4 broker says, "Well, I would like to go through why you would

 5 like to redeem them."

 6 And after the conversation, the broker recommends

 7 that the customer redeem those shares, and purchase shares of

 8 another fund that might be more appropriate for the customer,

 9 and then executes that trade. What part of that activity is

 10 designated for what fee?

 11 Arguably, when the customer first comes in and asks

 12 the broker, "How does redemption work?" That's a service

 13 fee. When the broker recommends a different fund, that's a

 14 fee for distribution. When the broker executes the trade,

 15 that's the part of the 12b-1 fee that goes to the broker's

 16 administration of the account. 

Page 92 
12b1transcript

 17 So, you can see by the example that it's a bit

 18 silly to try to distinguish the different aspects of that

 19 transaction. I think, as Paul was making the point earlier,

 20 we are really talking about one relationship that is a

 21 continuous relationship, and it requires a lot of dialogue

 22 between the broker and the customer. And to try to

 23 categorize the fees and cap them has been a very challenging

 24 process.

 25 MR. PLAZE: I would like to talk to you about C

 1 shares for a minute, while I've got you here, Tom. The NASD

 2 limits front-end loads to 8.5 percent, we know in the

 3 equivalents for 12b-1 fees. Then there are these C shares,

 4 which have been developed fairly recently, in which a fee is

 5 one percent charge, basically, forever.

 6 Now, we know from mathematical certitude, that at

 7 some point that will exceed 8.5 percent of the amount of

 8 purchase. Why don't the caps operate to limit the ability of

 9 the C shares to go on forever?

 10 MR. SELMAN: Well, we have two types of caps. The

 11 first cap is basically a one-percent cap on 12b-1 fees. The

 12 other cap is a cap that requires what we call a remaining

 13 amount calculation which, believe me, you don't want me to go

 14 into here.

 15 But it is meant to look at net new sales by the

 16 fund, and take into account further fund activity, and it's

 17 an overall cap that is meant to bring the total 12b-1 fees in

 18 a B or C class into some economic equivalence with the

 19 front-end load in an A. 

Page 93 
12b1transcript

 20 The C shares are subject to that cap. And B shares

 21 are also subject to that overall cap, as well as the specific

 22 one percent cap. But with both B and C shares, there may be

 23 points. For example, if somebody qualifies for a high break

 24 point, or a good break point on A shares, even with B shares

 25 it may exceed what they would have paid in a load with the A

 1 shares.

 2 It's just -- I think the reason why that happens

 3 is, first of all, there is no shareholder level accounting. 

4 There is fund level accounting for the cap. And

 5 second -- again, I get back to my earlier theme -- when a

 6 regulator attempts to try to create economic equivalence

 7 between different types of fees, it's extremely difficult to

 8 do that in a way that creates economic equivalence for every

 9 shareholder.

 10 MR. PLAZE: So, if I can understand -- and you tell

 11 me if I am incorrect -- the C shares go on forever, and in

 12 fact, an individual may pay much more than 8.5 percent. But

 13 the overall fund, the overall amount collected, would not

 14 exceed some economic equivalent, because of the fund level.

 15 MR. SELMAN: Well, I mean, theoretically, the way

 16 that the overall cap works, it's designed to create the

 17 potential that the overall fee you pay in B or C shares would

 18 not exceed the total load that you would have paid in the A. 

19 But the fact is, it's possible, and that happens.

 20 MR. PLAZE: Now, when 12b-1 fees, or any other

 21 fees, are used to support shareholder services, there is

 22 obviously a requirement that the board approve that use of 

Page 94 
12b1transcript

 23 assets as an appropriate use of assets.

 24 How, as a practical matter -- and we have heard

 25 recently from the mutual fund directors forum about the

 1 difficulty of doing this -- do funds and fund directors make

 2 sure that the services they're getting, or their shareholders

 3 are getting, are worth the amount they're paying?

 4 We have a letter, for instance, from -- we do read

 5 these e-mails that people send us -- Mr. Andrew Gross, who

 6 sent it on June 9, 2007. He said, "Although I'm charged this

 7 12b-1 fee every single year, I receive absolutely no services

 8 whatsoever from the broker that sold me my funds. I

 9 shouldn't have to pay them forever. The broker made a

 10 one-time commission. That should be it. When I buy a sofa

 11 or car, I pay once, not a trailing commission every year to

 12 the salesman for the rest of my life."

 13 Now, that's his issue, obviously, but it does

 14 illustrate an issue I would like you to address. And

 15 panelists, feel free -- Mr. Uek -- how do you oversee the

 16 services that brokers provide, and whether, in fact, the fund

 17 is getting its money for those services?

 18 MR. SELMAN: Well, I mean, I will let others

 19 discuss it, but if you're asking whether the customer is

 20 getting 25 basis points worth of service --

21 MR. PLAZE: Right.

 22 MR. SELMAN: -- the same question applies with any

 23 service. For example, an investment adviser charges a

 24 one-and-a-half percent fee. Some investment advisers may be

 25 providing a service that we would all agree is worth that, 

Page 95 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

and others might not. 

MR. PLAZE: But that's where the adviser is paying 

services to somebody, itself. This is where a third party is 

providing services to a shareholder. It's kind of an unusual 

arrangement, we have a third-party payment. 

MR. SELMAN: But I guess my point is that 

shareholders do have a choice with these fees, as well. I 

mean, to answer your question, undoubtedly for some of us, we 

would say that if a particular broker isn't providing 

adequate service, then we would choose another broker, or 

maybe go no load. But if others want to try to answer --

MR. PLAZE: But, generally, when a shareholder is 

paying his assets, that's his responsibility. When the fund 

is paying its assets to provide services, generally it's the 

fund's or the fund board's responsibility. 

And I think this was perhaps out in left field for 

you, Tom, at the NASD. Mr. Uek has his light on, so I 

presume --

MR. UEK: Well, I think first of all, in the first 

panel, Mr. Fink this morning suggested, I think, that 60 to 

70 percent of the accounts in the load world are in omnibus 

accounts. And Mellody just talked a little bit about omnibus 

accounts. 

My own speculation is that it's higher than 60 to 

70 percent. I might say that it approaches 80 percent. 

Page 96 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

Omnibus accounts, I think as many of us know, are single 

accounts, as Mellody talked about. And what's behind those 

in, say, the broker world, or in the platform world, are 

literally, millions of accounts. 

I believe there currently are around 100 million 

accounts in the United States, and the bulk of those are in 

omnibus accounts, of which very little is known about the 

omnibus accounts, because they are one transaction that 

happens to settle up net sales, net redemptions. And what 

happens with all those, and to what degree they're serviced, 

is within the broker-dealer community. 

Now, as Tom had suggested, there are in many dealer 

agreements levels of service that are kind of maintained, and 

there are conversations. 

But if your question is do the directors audit, if 

you will, the service level that goes on in 100 million 

accounts, the answer is no, they don't. And there are -- in 

the case of MFS, there is a marketing sales committee of the 

board, which meets at each meeting, which is 10 times a year. 

And conversations are had around this issue all the time. 

But we do not have any particular procedures. 

And I would suggest that the large entities that 

are really controlling the business didn't get there because 

they are offering lousy service. The fellow that you alluded 

to, and the fellow that wrote you the letter, my guess is

 1 whoever his broker is isn't going to be his broker very long,

 2 and he is going to migrate somewhere else.

 3 So, if you have a habit of continuing that 

Page 97 
12b1transcript

 4 behavior, you're not going to be in the business very long as

 5 a major player. So I think it's in the self-interest -- and

 6 if you look at the number of millions of accounts that these

 7 distributing arms have, they are obviously doing the job

 8 right for many people. Maybe not all, there may be some at

 9 the margins, but we don't get a lot of feedback that's

 10 adverse back from us.

 11 We hear certain things through our shareholder

 12 servicing arm. But most of those are way down the arm of the

 13 distribution network. So the answer is no, we don't get a

 14 lot of that --

15 CHAIRMAN COX: Bob, I thought that the example that

 16 you provided was a useful example, but it may be that we're

 17 discussing it through a significantly different pair of

 18 lenses here.

 19 Because the suggestion has been made here that the

 20 fellow who wrote the SEC the letter should get a new broker,

 21 because the broker is not providing the level of service that

 22 he expects. But I didn't understand it that way. I thought

 23 that he was saying is he got exactly what he expected, but

 24 that that service, having been provided, should not be

 25 forever compensated.

 1 MR. PLAZE: Right.

 2 CHAIRMAN COX: Isn't that a different question?

 3 MR. UEK: Okay, all right.

 4 CHAIRMAN COX: So, what's the answer to that

 5 question?

 6 MS. HOBSON: Well, one thing, I mean, I would just 

Page 98 
12b1transcript

 7 chime in here. The letter in isolation does not provide

 8 enough information, because we don't know if this gentleman

 9 calls direct to the mutual fund company to ask them questions

 10 about the portfolio --

11 CHAIRMAN COX: Right, but let's not make it any

 12 harder than it needs to be. Let's just take it at face

 13 value, and assume that this is an investor who bought a fund

 14 who wanted to be a long-term owner -- or at least who wanted

 15 to be an owner through the date that he wrote the letter, and

 16 that his complaint is as he states it. And what's the answer

 17 here?

 18 MS. HOBSON: In that situation, I would say that he

 19 either needs a different broker, if he would like more

 20 service, or --

21 CHAIRMAN COX: But he's not asking for more

 22 service.

 23 MS. HOBSON: Then he should have a fund with no

 24 12b-1 fee. And they're out there. I mean, that's the great

 25 thing, there are lots of choices.

 1 CHAIRMAN COX: And so, his beef with his broker is

 2 that he shouldn't have bought a fund with a 12b-1 fee in the

 3 first place, is that right?

 4 MR. HAAGA: He is -- whether he wants to or not, he

 5 is a do-it-yourselfer. I would wager -- look the guy up,

 6 because apparently he's one of our shareholders.

 7 (Laughter.)

 8 MR. HAAGA: I would wager that he is not retired,

 9 because -- and, you know, he may be just in a happy halcyon 

Page 99 
12b1transcript

 10 five-year period, when he doesn't need any help. But if you

 11 look at his life span, I'm not so sure that he hasn't gotten

 12 any help. And maybe it wasn't worth this. But a

 13 do-it-yourselfer doesn't belong with us, and we don't offer

 14 our shares to do-it-yourselfers.

 15 But can I answer Bob's question, because I disagree

 16 a little bit with Bob. You can't monitor services directly,

 17 but you can certainly monitor the quality of services

 18 indirectly. We don't have to sit with every broker, and see

 19 how often they're calling people.

 20 There are a number of ways we monitor. For one, we

 21 have a transfer agent, that is a shareholder servicing agent,

 22 that maintains the shareholder accounts. They get 24,000

 23 incoming calls a day to ask specific questions about

 24 shareholder accounts. No marketing, no distribution. This

 25 isn't where you call if you want sales material. 17,000 of

 1 those 24,000 calls come from brokers or brokers' assistants. 

2 So, somebody is giving ongoing services to somebody by that

 3 number. It's not where you call to buy shares, it's where

 4 you call to service an account.

 5 Secondly, we have a group of 100 people now called

 6 our home office service team that actually goes out and meets

 7 with firms that use our shares with their clients, advisory

 8 clients, and actually oversees and talks to them about how

 9 they do their services.

 10 They do it partly because sometimes -- they do it

 11 mainly with the subtransfer agents, or the street name

 12 accounts, to make sure they're actually getting valid service 

Page 100 
12b1transcript

 13 and accounting. But they also visit the people, the firms,

 14 and talk to them about what kinds of services they're

 15 providing through the 12b-1, and we check to see that the

 16 literature is getting mailed out and used with the clients.

 17 And, third, we provide complaint letters -- more

 18 likely complaint e-mails -- to our directors on a regular

 19 basis. And the executives, I get a list of the

 20 e-mails -- or, actually, a copy of the e-mails -- that have

 21 been forwarded on to our web site once a week, and I just

 22 kind of flip through it quickly, and look to see what people

 23 are saying about the services they're getting from us, the

 24 services they're getting from their adviser, and we use that

 25 to monitor it.

 1 And we're very pleased with the level of service,

 2 but we have occasionally had to cut off a dealer agreement

 3 with somebody, because they weren't providing the appropriate

 4 level of services for which they're being paid.

 5 MR. UEK: I think Paul's comments are well taken,

 6 and they're from his perch in the management company complex

 7 or, as I think my comments were trying to be directed, from

 8 the position of the board of trustees of the fund complex. I

 9 don't think there is an inconsistency.

 10 MR. PLAZE: Okay. We have 15 minutes left. I

 11 would like to use this time for the panelists -- we have

 12 seven; this is the largest panel of the day -- to each spend

 13 a couple of minutes summarizing -- this is their opportunity,

 14 as Doug gave the previous panelists -- their points of view

 15 on the subject matter at hand. 

Page 101 
12b1transcript

 16 Please start, Marty, with you, and go right down

 17 the --

18 MR. BYRNE: Sure. In my view, Rule 12b-1 has

 19 provided substantial benefits to investors, in providing them

 20 with choices and simplicity, a choice that they can decide

 21 how they want to pay for fund shares and the distribution of

 22 shareholder services they receive either up-front, over time,

 23 or back-end. And simplicity, in that it's done -- all the

 24 expenses are bundled into a single vehicle.

 25 Also, I think that the view that payments to

 1 broker-dealers and other intermediaries is not distribution

 2 or advertising is not necessarily appropriate.

 3 I don't personally see much difference between

 4 using, you know, a 12b-1 to do newspaper, direct mail,

 5 television advertising, or going to a financial services

 6 company that, like ours, has 16,000 financial advisors who

 7 are marketing these funds, have information relating to the

 8 funds, are handing out marketing literature, prospectuses, to

 9 over two million shareholders.

 10 Both are distribution, they're done in a slightly

 11 different way. But I think they're both beneficial to the

 12 funds and, ultimately, to investors.

 13 MR. PLAZE: Tom, from your perch as a fellow

 14 regulator?

 15 MR. SELMAN: Well, I guess if I might be so

 16 presumptuous, it seems to me that the basic question that's

 17 being asked is whether there should be a demutualization of

 18 these fees, whether the fee should be incurred by customers 

Page 102 
12b1transcript

 19 at the intermediary, the broker-dealer level, rather than at

 20 the fund level.

 21 And I guess my question is, why does it have to be

 22 either/or? For example, the service fee, if we were to

 23 assume that the 25 basis-point cap on service fees doesn't

 24 work too well, we can pretty much guess that a zero cap would

 25 be even worse. What would happen is that services would

 1 probably go down, or the fees would simply go up elsewhere,

 2 or perhaps other products would be sold.

 3 I think, instead of deciding either/or, the binary

 4 decision of either maintaining 12b-1 and restricting the

 5 ability of intermediaries to price their services, or moving

 6 everything out at the intermediaries, I think we should

 7 preserve 12b-1, but encourage new types of fee arrangements

 8 at the intermediary level. And I will give you two examples.

 9 One is 22(d), the retail price maintenance

 10 provision in the 40 Act, which, for example, prohibits a

 11 broker-dealer from simply charging its own commission for the

 12 sale of a fund at NAV, like they would a stock. There is no

 13 reason, really, why that restriction still should be in

 14 place.

 15 The other, of course, is the fee-based brokerage

 16 issue that we all have been grappling with. I think the more

 17 fee arrangements you allow a broker-dealer to develop with

 18 its customers, the more competition you have with 12b-1 fees.

 19 And likewise, for example, C shares could compete

 20 with the broker-dealer's own fee arrangements, so you would

 21 have a competitive momentum to try to reduce expenses 

Page 103 
12b1transcript

 22 overall, and give customers more choice.

 23 The only thing I would add is that, other than more

 24 choice, I think that customers need simplified disclosure. 

25 We continue to feel that way. Our Profile Plus, for example,

 1 would not have included the entire fee table, it would have

 2 just included the total return -- the total expense ratio.

 3 When you buy a car, for example, you're not

 4 interested in how much of the purchase price goes to the

 5 marketing company that marketed the car, or the auto parts

 6 dealer that provided the parts, or the designer of the car. 

7 You're interested in the sticker price. And we still feel

 8 that that's the number -- of course, you need to preserve the

 9 fee table and the full prospectus, but it's that total

 10 operating expense ratio that investors really need to focus

 11 on, that needs to be put squarely in front of them.

 12 MR. PLAZE: You might want the retailer's invoice

 13 number, also, to find out how much buying that car goes

 14 to -- anyway --

15 MR. SELMAN: Sure. Right.

 16 MR. PLAZE: Charlie?

 17 MR. NELSON: Thanks. You know, I think, clearly,

 18 12b-1's are an important and critical part to the retirement

 19 market. Sterling Research does a study each year, and

 20 measures profitability of retirement providers. From 2003 to

 21 2005, 48 percent of the companies surveyed would have been

 22 break-even or less.

 23 Now, if you take away 12b-1's, that number goes to

 24 64 percent of providers break even or less, record-keepers in 

Page 104 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 25 the retirement market. Now, obviously, less competition is 

not good. We think that more competition is good for the 

market. 

But then what's the next alternative? And I think 

in the retirement market, we probably have some other 

alternatives that are becoming more popular. If 12b-1s were 

changed, I believe what will happen is people will go to 

other unregulated, separately managed accounts. You can get 

to the same point, and still pay the important adviser along 

the way. 

So, they will just go to other solutions and other 

types of investment media. Because investment advisers do 

provide a very important, very valuable, and critical 

service, in particular to that small to micro end, which is 

96 percent of plan sponsors in the 401(k) market. So if 

that's the largest segment, we've got to make sure we 

continue to provide services, both to participants, as well 

as to plan sponsors. 

And I think that they will have to get paid one way 

or another, it will either be through 12b-1s, or they will go 

through other sources, or other types of investment media, 

where they can get that type of compensation. 

MR. UEK: As a director, I wanted to spend just a 

moment -- it's not this panel -- to underline a few comments 

made in the previous panel about the factors, the nine 

factors that were adopted in 1980. 

Page 105 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

I think those of you who have a chance to go look 

at those, I think you will find that all or substantially all 

of those, are badly outdated, and need to be reformed, either 

in a generic blueprint, or in a new list. 

I think, from my director's view, I would suggest 

that some generic guidance there, that each fund group figure 

out the facts and circumstances that are relative to itself. 

I think that is very important. 

Second of all, several people have discussed 

disclosure today. I would certainly be with that group that 

suggested that this industry could do a much better job, in 

terms of disclosing either where it is, or in different 

places, what is happening with 12b-1. Paul's comment that 

12b-1 should be disbanded, it sounds like a couple of tax 

people talking about tax sections. You can't follow a 

conversation, the average person. I think we can do a lot 

better, in terms of plain English, and explaining what it is 

that's here, in a robust but simple way. 

And then, finally, I would say there are really 

four words that enthused me here. One is "advice," one is 

"choice," one is "scale," and one is "mutualization." And 

the advice is the one that I think about the most these days. 

I think Mr. Donohue suggested, in his opening remarks, that 

half of America now owns these products. 

I think most of us view that, and say, "What

percentage of that half of America do we think is financially 

Page 106 

 1 
12b1transcript

 2 literate, in terms of either the experiences they have had,

 3 the education, the economic background, personal finance?" 

4 And I suspect we may all think that, "Gee, it's a pretty

 5 small part."

 6 And so, the question is, since we have now entered

 7 the brave new world of moving retirement assets, among other

 8 assets, from defined benefit to defined contribution here,

 9 who will provide these people that are not financially

 10 experienced, the advice and counsel, so that they make the

 11 right decisions, in terms of the right mix of assets, so that

 12 when they get to be 60-something, then, in fact, there is

 13 enough money so that they can live in a retirement mode,

 14 somewhat similar to what their parents did under defined

 15 benefit.

 16 Well, that worries me a lot. MFS has millions of

 17 shareholders, and I know all those millions of shareholders

 18 are not consistent with a deep, financial knowledge.

 19 So, the 12b-1s, it seems to me, provide the

 20 opportunity not just at the outset to figure the suitability

 21 of the investments for those individuals, but also the

 22 mid-course corrections, in terms of their life experiences,

 23 and in terms of the change of markets, in terms of

 24 reallocating their assets amongst domestic and international

 25 and fixed, et cetera, et cetera.

 1 And then, also, as they get later in life, people

 2 like me here, they worry about whether you are going to

 3 outlive your assets or not, in terms of -- again, what's the

 4 component, what's the draw-down, et cetera. It seems to me 

Page 107 
12b1transcript

 5 there are multiple points in your life that you need advice

 6 and counsel. And it seems to me that 12b-1 allows that to

 7 happen.

 8 The other points I talked about, choice, I think we

 9 heard from the first panel, from Ms. McGrath for example, and

 10 that's consistent with my own kind of observations, is that

 11 people don't like front-end loads, and they don't like loads,

 12 and they like to have something kind of over time. And I

 13 think that's right, and I think that 12b-1 has offered them a

 14 choice.

 15 And we haven't talked much today about the

 16 proliferation of share classes, but there are an awful lot of

 17 share classes out there, in many, many load groups.

 18 Finally, scale -- my penultimate point -- scale, I

 19 think if we look around in the capitalist world, and we look

 20 at the trends of what has happened in modern times here,

 21 people realize scale is important in every industry, to drive

 22 down cost and deliver value. I think 12b-1 has allowed a lot

 23 of scale to happen in this business, as it's moved from -- I

 24 think Mr. Donohue said it was $50 billion when he came into

 25 the business, and it's now something on the order of $12

 1 trillion.

 2 There are a lot of reasons why that happened, but I

 3 think, personally, one of the components is 12b-1, which has

 4 allowed a lot of advice and counsel for people to get it.

 5 And my final point is mutualization. We could

 6 dismantle all the expenditures in a fund, and put them all

 7 outside the fund, and my guess it that wouldn't be in the 

Page 108 
12b1transcript

 8 best interest of anybody, it would create confusion.

 9 And so, my thought is pulling 12b-1 out isn't any

 10 more valid than pulling custody out, or shareholder

 11 accounting, or anything else. I think the mutualization of

 12 12b-1 is important, and I think it's served this industry

 13 well. This industry still can put product on the street in a

 14 less expensive expense ratio than virtually any other segment

 15 of the financial services.

 16 And so, it's okay with me, the way it is. 

17 Concentrate on disclosure, and concentrate on the advice. 

18 Kind of that's where I am.

 19 MR. PLAZE: Thank you. Mr. Morris?

 20 MR. MORRIS: Yes. We feel that 12b-1 fees need a

 21 slight upgrade, not a major overhaul. We do, as well,

 22 support removing the jargon 12b-1 fees, and providing a more

 23 descriptive, plain-English way of describing these fees, so

 24 that investors are really better able to understand their

 25 purpose.

 1 We also support the ICI recommendation, to include

 2 a glossary of terms used in the prospectus, really clearly

 3 defining these fees.

 4 With respect to any proposed change in Rule 12b-1,

 5 we should be very, very thoughtful about the potential for

 6 creating unintended, adverse consequences for individual

 7 investors. We believe that the benefits of supermarkets to

 8 investors are so important, that the SEC's overarching goal

 9 in examining 12b-1 should be preserving this remarkably

 10 democratizing way of ensuring that investors have access to 

Page 109 
12b1transcript

 11 thousands of different funds.

 12 MR. PLAZE: Thank you. Ms. Hobson?

 13 MS. HOBSON: I have three points to make in my

 14 summary.

 15 First, we believe that 12b-1 fees really give

 16 smaller mutual fund companies a fighting chance against the

 17 big guys, and that's not a small task for us on a daily

 18 basis. It allows us to sit side-by-side on the shelf of

 19 supermarkets, brokerage firms, or 401(k) plans against bigger

 20 mutual fund companies.

 21 It also allows us to offset -- and I want to put

 22 the emphasis there -- the cost of marketing the funds. But

 23 it is not a profit center, as I said before.

 24 Second, we would argue that, in our case, 25 basis

 25 points is a low price for the ongoing advice and service that

 1 our 1.6 million shareholders get. And when you really put

 2 that 25 basis points in context, a $1,000 account is paying

 3 $2.50 a year for a lot of support, from our perspective. 

4 That's everything from the web site to the phone access, to

 5 many of the other things that we provide, regardless of where

 6 the fund was sold, regardless of if the broker was a good

 7 broker or not. That support still exists, and is there.

 8 Last, but not least, we would argue that the

 9 issue -- and I would argue -- the issue of disclosure is

 10 something that is extraordinarily important. It clearly has

 11 been highlighted here. But I do think that there is the risk

 12 of peeling the onion a little too far, when it comes to this

 13 issue. 

Page 110 
12b1transcript

 14 And it gets confusing for everyday people who, at

 15 the end of the day -- and I think one of my colleagues

 16 already said this on the panel -- should be, and are, most

 17 concerned with the bottom line of what they're paying.

 18 Service and distribution is a cost of anything that

 19 you buy in this country. And we know that from higher energy

 20 prices, those costs have been passed on, in terms of higher

 21 prices, right now, in terms of lots of products.

 22 But the mutual fund industry is really one of the

 23 only industries that breaks this cost out, so that people can

 24 see it in real time, which I think is terrific, but I also

 25 think can be confusing.

 1 So, at the end of the day, is there a better way to

 2 do this, that still allows us to have all of this, all of

 3 these benefits? Perhaps there is. But I would also -- and

 4 is there potentially a better name for this, that provides

 5 more clarity? Maybe that's the way to go. But at the end of

 6 the day, we think the actual essence of what this rule

 7 provides for the millions of shareholders who are out there

 8 of all mutual fund companies is unarguable.

 9 MR. PLAZE: Mr. Haaga, you get the last word. But

 10 the price of that is it's got to be a short one.

 11 MR. HAAGA: Okay, thank you. I sure will. Let me

 12 thank, again, the Commissioners for having us and me.

 13 I have heard this, once again, mutual funds

 14 compared to products. I think I heard automobile,

 15 refrigerator, sofa so far today. They're not products;

 16 they're services. They are ongoing relationships, they're 

Page 111 
12b1transcript

 17 not something that gets sold and walked away from. And the

 18 more we try to deal with these issues by analogizing consumer

 19 products, the harder time we're all going to have.

 20 There is a lot of complexity here. I apologize, in

 21 some ways, for this. But, you know, choice is the enemy of

 22 complexity. So, unless you're complex, you don't have many

 23 choices. And we try to balance it out, and have the right

 24 amount of choice, with a reasonable amount of complexity, and

 25 that's what got us to this number of classes.

 1 I am just going to focus on one part of this. And

 2 you notice I haven't said those words I said I wouldn't say. 

3 And that's the service fees, the 25 basis points on the A

 4 shares, 80 percent of our assets are in A shares, 80 percent

 5 of our expenditures, pursuant to the rule are on service fees

 6 on A shares.

 7 Our average account size is $25,000, and 60 percent

 8 of our accounts are under $10,000. So that's the person I am

 9 thinking about when I talk about making these distinctions.

 10 I think Tom Selman had it right. This is not a

 11 question about whether -- I don't think it's a question about

 12 whether brokers, advisers, provide services to shareholders. 

13 And I don't even think it's a question of how they ought to

 14 be paid. I think most people agree that payment over time is

 15 better than payment only for transactions.

 16 And I think most people would be willing to concede

 17 that some services are being provided to shareholders. The

 18 question we're dealing with today is just should those be

 19 externalized or mutualized. And let me give you the case for 

Page 112 
12b1transcript

 20 mutualization.

 21 We're buying in bulk, in effect. We set the fee at

 22 25 basis points that will be paid to the advisers. We don't

 23 get any of it. And, moreover, it gets deducted from our

 24 reported investment results. So we have an incentive to set

 25 it as low as we can, to still get the job done.

 1 There is also a tax advantage, that some people

 2 have mentioned. There is also a simplicity to it, and I

 3 don't want to overlook that, that our being the paymaster is

 4 a lot easier than asking each adviser to go out -- remember,

 5 on a $25,000 account, that's $62, I think it is, a

 6 year -- it's a lot easier for us to pay it, and us to credit

 7 to the firms, than it is for the advisers themselves to go

 8 out and collect it. So it's going to be lower, just because

 9 we have borne the administrative burden.

 10 I think there are a lot of things to like about the

 11 mutualization of these fees, just like there is to like about

 12 the mutualization of transfer agent fees, advisory fees, and

 13 others.

 14 And, finally, I am terribly sorry about the guy who

 15 wrote the letter, but let's not solve this problem

 16 anecdotally. We will fix him, but let's not unfix things for

 17 another -- for 50 percent of American families, just so we

 18 can deal with the poor guy who never calls his broker. I bet

 19 he doesn't go to the dentist, either.

 20 (Laughter.)

 21 MR. HAAGA: So, I will leave it at that. Thank

 22 you. 

Page 113 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 23 MR. PLAZE: Thank you very much. This concludes

 24 our second panel. There will be a break, now, for lunch.

 25 I would like to thank the panelists very much for 

their participation. I thought it was a good panel. We will 

resume again at 2:00 this afternoon for a panel entitled, 

"The Costs and Benefits of Rule 12b-1 Plans." I know that's 

my favorite part of every SEC release. So I'm sure you will 

be back to listen to it. 

(Whereupon, at 12:30 p.m., a luncheon recess was 

taken.) 

A F T E R N O O N S E S S I O N 

PANEL THREE -- THE COSTS AND BENEFITS OF 12B-1 PLANS 

MR. SIRRI: All right. Why don't we get started? 

Welcome back from our lunch break. This panel will be about 

the costs and benefits of Rule 12b-1 plans. My name is Erik 

Sirri, I am the Division Director from the Division of Market 

Regulation. 

We're pleased to have a distinguished panel with us 

to discuss this topic. Let me introduce them. Starting from 

your right, on the far right of the table, is Brad Barber, 

who is a professor of finance at UC Davis. 

Next to him is John Hill, who is the independent 

chairman of the Putnam Funds. 

Next to him is Jeff Keil. Jeff is the principal in 

his own firm, Keil Fiduciary Strategies. 

Next to him is Joseph Russo, who is the chairman 

and chief executive officer of Advantage Financial Group. 

Next to him is Michael Sharp, who is the general 

Page 114 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

counsel of Citi Global Wealth Management. 

And on the far end of the table is Shannon 

Zimmerman, who is an investment analyst at the Motley Fool. 

So, let me thank you all for joining us here today 

to talk about this topic. We will follow, broadly, the same 

scheme we had last time. We will go through the panel, we 

will leave about, oh, I would say about 10 to 15 minutes at 

the end for closing statements of 2 to 3 minutes each. We 

will go down the line for that. I will try to get you in for 

comments. Just signal to me, raise your hand, do something 

like that. I will try and call on you, to keep a reasonable 

amount of order here, if we can. 

So, why don't we start? I think what's a little 

different about our panel is that we're going to cover a few 

things that haven't been talked about yet. Obviously, as the 

title suggests, it's going to be about economics, in some 

sense. We're going to talk about the cost and benefits of 

12b-1 plans. 

And, in particular, I think we're going to pay some 

attention to the individual investor, what their role is, and 

what the information set is that they have, and how they 

think about the various kinds of fee charges they face. 

So, let me start us off. And let me start, 

Michael, with you, if I could. 12b-1 plans, why are they so 

popular with the fund industry? Is the story really that 

Page 115 
12b1transcript

 1 this is just a cost-effective way of paying for distribution

 2 and shareholder services? Or, in fact, is this a method to

 3 obfuscate charges and costs of funds?

 4 MR. SHARP: I think it's clearly the former, and I

 5 think it's important that you pointed out that we will focus

 6 on investors. Because I think, with this dialogue, we need

 7 to think about what's right for investors, and what's in

 8 investors' interests. And I think 12b-1 fees are in

 9 investors' interests.

 10 In fact, at the earlier session, when we heard the

 11 letter from the disgruntled client, I was sitting down and

 12 fidgeting, and I wanted to raise my hand and say, "I know the

 13 answer, teacher."

 14 There are many, many services that are given to

 15 clients. And they're given to clients in a way that is sort

 16 of in an integrated way that neither the funds nor the

 17 individual investors could pay for more efficiently or more

 18 cheaply on their own.

 19 And it's not just -- it's hard to define exactly

 20 what the services are. I could give you a list of -- I had

 21 one of my guys put a list together of things that we do for

 22 clients, and the list is over 70 items long. It's the web

 23 sites we provide, it's the asset allocation information. 

24 It's the information that goes into statements educating them

 25 about mutual funds. It's the incremental advice that is

 1 given on any given time about mutual funds. It's introducing

 2 them to the whole panoply of the share classes that are out

 3 there. It's introducing them to the differences between the 

Page 116 
12b1transcript

 4 share classes.

 5 There are many, many things that happen, not only

 6 at the time of sale, but throughout the entire duration of

 7 the investment, and into the next investment. And I think

 8 that having the 12b-1 fees out there puts the client and the

 9 FA on the same side of the table, because it gives the FA the

 10 ability to have an ongoing interest in the client. And

 11 likewise, the client has the FA looking out for his or her

 12 interests. And I think that's a crucial thing, and I think

 13 it has worked.

 14 I think, when you look at 12b-1, and you look at

 15 the way the industry has grown over the past 27 years since

 16 12b-1 has been out there, I think it's a clear success. I

 17 think the SEC has done a great job in the way it formed this

 18 in the beginning, and the way it continues to look at it even

 19 now. And I commend the Commission for looking at it, even

 20 now. It's a strong rule, but it needs to be looked at.

 21 MR. SIRRI: So, just so folks have some sense of

 22 who receives 12b-1 fees, could you describe, in just two

 23 sentences, what your business looks like?

 24 MR. SHARP: Say that again, I'm sorry.

 25 MR. SIRRI: You receive 12b-1 payments. What does

 1 your business look like? What does your brokerage business

 2 look like?

 3 MR. SHARP: Yes. The overall business, we have a

 4 large business. We have about 13,000 FAs out there, and

 5 probably slightly more than half of our business is

 6 fee-based, usually advisory, but some non-advisory fees. And 

Page 117 
12b1transcript

 7 the rest is transactionally based.

 8 And on the mutual fund side of the business, it is

 9 a combination of front loads and 12b-1 fees that are used to

 10 compensate the FAs. And depending on how much production you

 11 have as an FA, you will have somewhere between -- you will

 12 get 25 to roughly 42 percent of those fees, as they come in.

 13 MR. SIRRI: Thanks. Joe, you run a slightly

 14 different business model. I wonder if you could talk about

 15 your view of 12b-1 fees, and if you would preface that by

 16 talking about what your business looks like.

 17 MR. RUSSO: Sure. My business is much smaller than

 18 Michael's, and it's, frankly, tough to add to what Michael

 19 has said, in terms of the value of 12b-1, or that section

 20 which allows ongoing service, ongoing relationships. My

 21 business is an OSJ, an office of supervisory jurisdiction. I

 22 have 28 branches, 81 partners, a couple of billion dollars

 23 that we manage.

 24 And the long and the short of it is we have 33,000

 25 clients that we have been building relationships with for 35

 1 years. And those relationships, over the last 20 years, to a

 2 great degree, have been paid for, financed, by the very

 3 effective, tax-efficient, 12b-1 fee.

 4 And that is a mutual trust relationship that is

 5 built between middle America, the small and moderate-sized

 6 investor, and the financial community. That mutual trust

 7 relationship lasts until you die, in most cases.

 8 I'm a big advocate for this. I believe that we're

 9 doing right to look at it again. And somebody did very right 

Page 118 
12b1transcript

 10 20 years ago, when they established this in the first place,

 11 because it works. There was $50 billion in mutual funds, and

 12 now there is $7 trillion in mutual funds.

 13 And, largely, that's because you have financial

 14 advisors looking for the best interests in clients, who need

 15 that ongoing service, ongoing education, tax advice, the

 16 support that comes as part and parcel of what the independent

 17 adviser does.

 18 MR. SIRRI: Shannon, I think of you as having a

 19 sort of investor advocacy lean. Would you agree with what

 20 you just heard?

 21 MR. ZIMMERMAN: No. With all due respect to all of

 22 my panelists, I think I will have a slightly different take

 23 on the issue of 12b-1 fees.

 24 And just to pick up on one of the themes of our

 25 panel, and a comment that Paul was making earlier, too, you

 1 know, there is a lot of conversation in the industry about

 2 customers and products, and not nearly so much as there

 3 should be, I think, about investors and investment vehicles.

 4 And, on some level, you can kind of understand why

 5 that's the case, right? There is a host of services that

 6 are, indeed, provided. People enjoy receiving consolidated,

 7 quarterly statements. They also like state-of-the-art web

 8 sites, it makes it easy for them to check out their personal

 9 returns.

 10 To my way of thinking, those are ancillary to the

 11 investment vehicle that is the mutual fund. And the problem

 12 that 12b-1 invites is that it conflates those charges, it 

Page 119 
12b1transcript

 13 puts the charges for the services in the context of the

 14 investment vehicle, and the investment vehicle becomes worse,

 15 the higher the expense ratios become.

 16 At the end of the day, what people are investing in

 17 are the returns those investment vehicles can deliver for

 18 them, and they are necessarily worse than they would be, as a

 19 result of higher expense ratios.

 20 Just to speak to the latter point, there is

 21 a -- conflict of interest may not be the right word, but

 22 there is a tension between the fact that 12b-1 fees are used

 23 for marketing and distribution to pump up fund assets, and

 24 the performance of those mutual funds for the individual

 25 investors. It isn't the case that the larger the asset base,

 1 the better the fund. In fact, it's the opposite.

 2 One of two things tends to happen, right? If it's

 3 a large cap fund, it morphs over time -- as it receives more

 4 and more assets to put behind fewer and fewer compelling

 5 investment ideas, it morphs over time into an index hugger,

 6 right? An over-priced index hugger.

 7 And then, if it's a small cap fund, there is

 8 frictional costs, because the more assets the small cap

 9 manager has to put to work, it becomes more and more

 10 difficult for that manager to move in and out of the kinds of

 11 investments they like, without moving prices in the wrong

 12 direction.

 13 So, setting aside the question of whether or not

 14 12b-1 fees pay for services that investors need and want -- I

 15 believe that they do -- my view is that those services should 

Page 120 
12b1transcript

 16 not be paid for in the context of the investment vehicle

 17 itself.

 18 MR. SIRRI: Brad?

 19 MR. BARBER: Well, I guess I'm going to sort

 20 of -- I'm the lone academic today; what happened to all of my

 21 profession?

 22 Let me just say that I will sort of bring a

 23 somewhat different perspective to this, based upon the

 24 research that me and many of my colleagues in the academic

 25 profession have been taking on.

 1 And I think one of the things that has been lost so

 2 far is that, in surveys, 80 percent of investors do not know

 3 what they're paying, and what their expense ratio is for the

 4 largest mutual fund they hold. That's from a study by

 5 Alexander Jones in 2001.

 6 And in addition, I think there has been a secular

 7 shift in the industry away from front-end loads towards sort

 8 of 12b-1-type fees, or the multiple class of shares.

 9 In 1962, 91 percent of fund assets were in load

 10 funds. In 1999, 35 percent of equity fund assets were in

 11 funds that charged front-end loads. So, clearly, there has

 12 been a secular shift away. And I think what you hear from

 13 the industry -- and the message I hear over and over

 14 again -- is that investors do not like front-end loads.

 15 There is a simple psychological reason for that. 

16 It's an in-your-face fee. When you pay a load fee, it comes

 17 immediately out and off the top. Whereas, if you pay a

 18 spread fee over time, it's less obvious and less salient. 

Page 121 
12b1transcript

 19 The question is whether most investors who are not

 20 financially literate can do the calculus to make choices that

 21 are optimal for them. And I think there is evidence that

 22 that is a very difficult thing to do.

 23 To be clear, I think the advisory services to be

 24 provided by the profession are extremely important and

 25 valuable to what is largely a financially illiterate

 1 populous, unfortunately. However, I think that should be

 2 transparent and communicated effectively.

 3 And let me repeat that, because I think it's the

 4 most important message that I have today is that I would like

 5 to see transparent and effective communications of what the

 6 fees for those services are, and I simply don't think that

 7 the 12b-1 fees are, the label alone is obscure, "12b-1."

 8 I'm not suggesting the fees are not justified; they

 9 very well may be justified. But I think that it should be

 10 communicated that these are fees for ongoing service to be

 11 provided to clients, and the web sites, et cetera. Many

 12 investors would choose to pay for those services. But I

 13 think it's important that it's transparent that they do so.

 14 MR. HILL: Yes, I guess I share some of my

 15 colleague's on my left, here, point of view on this topic. I

 16 was listening to the panel this morning, and some of the

 17 comments earlier.

 18 I think I may be looking at a different 12b-1 than

 19 a lot of people look at. It sounded earlier like it was the

 20 best thing since sliced bread, and it makes me wonder why we

 21 have, on our board, all these issues with it, why this 

Page 122 
12b1transcript

 22 commission is even holding this hearing, if it's that good.

 23 I think it's disingenuous to say these are some

 24 important services, ergo we need 12b-1. There is no question

 25 that investors need services. And a variety of investors

 1 need different services for different abilities. And it has

 2 to be paid for. But to sort of move from that position to,

 3 ergo, let's don't touch 12b-1, as I said, I think that's

 4 disingenuous.

 5 I think if it is that good, we ought to be telling

 6 investors about it every chance we get, when they purchase a

 7 share, what the 12b-1 charge was. It ought to come out of

 8 their account, it ought to be on their annual statements. If

 9 it really is that good, they ought to know about it, and it

 10 ought to be spelled out.

 11 Secondly, I think it's the only way they will know

 12 they're paying for services which they may not be getting. 

13 So I think it really begs the question to go from services to

 14 this type of thing. There has got to be a much more

 15 economically fair way.

 16 MR. SIRRI: And, to be clear, could you describe

 17 Putnam's use of 12b-1s?

 18 MR. HILL: Our 12b-1 fees are much like the rest of

 19 the industry. I think it's clear to us, at least, that if

 20 Putnam didn't have a program, a lot of brokers wouldn't sell

 21 our funds. The answer is always the same, it's got to be an

 22 industry solution. I'm getting less of that today, because B

 23 shares are on the decline. We're seeing less and less of

 24 them. But we use them, but it's actually turned out to be 

Page 123 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 25 quite a small percentage in recent years. 

MR. SIRRI: Mike? 

MR. SHARP: No, I think that -- just going to 

respond to the B share point. I think B shares are, indeed, 

on the decline. 

But I think that when we're talking about 12b-1 

fees, there are two sides to 12b-1 fees. There are the fees 

that are kept to finance B shares, and there is the 25 basis 

points that goes to the distribution point for the servicing 

and advice, and I think those are two different things we 

need to distinguish. 

MR. KEIL: I think, certainly to echo my fellow 

panelists' points about there are certain benefits to 12b-1 

plan expenditures, whether it be plan administration, 

supermarket payments, or what have you, there are obviously 

pricing options. So there is no question there. 

I would like to address Mr. Zimmerman's point about 

the expense load and the reduced performance. I think that 

what's minimized in that discussion is that the -- if -- the 

investor, left to their own devices, what performance would 

they have realized, versus what they get with advice from a 

financial advisor? And, obviously, was that service fee 

covered by the excess -- if you want to call it 

that -- performance? Presumably, excess performance. So I 

think it's not as simplistic as you may have us believe. 

MR. SIRRI: If I listen to what you said, it seems 

Page 124 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

like you've divided the world -- there are two pieces to 

this. There are the services the broker provides, and then 

there is a question of how you pay for those services. 

What is your -- thinking about the investor side of 

things, is there any sense that brokers aren't providing the 

right basket of services today, because of the way we price 

those services? Shannon? 

MR. ZIMMERMAN: If I can say a word on my own 

behalf, I certainly don't mean to suggest a simplistic 

rationale for the line of argument I was making before, and I 

really do want to emphasize that I am not saying that the 

services that are provided for and that are paid for by 12b-1 

fees are not worthwhile services. Clearly, they are. 

And if you're working with someone who is 

knowledgeable, and has your best interests at heart, it 

stands to reason that, over time, you would have greater 

returns than you would if you were just sort of winging it 

and throwing darts. I don't mean to suggest that at all. 

My question has to do with whether or not the 12b-1 

is the most appropriate way to pay for those services. I 

don't feel that it is. And just if I could, just to speak to 

Brad's issue about transparency, I am a big fan of greater 

transparency and disclosure. 

My concern, though, is that that isn't sufficient. 

You can know if your fund is paying a 12b-1 fee, and you can

know what your fund's expense ratio is. Are you motivated by 

Page 125 

 1 
12b1transcript

 2 that? I don't know.

 3 There was a study last year, put together by some

 4 professors at Wharton and Harvard and Yale that -- it was

 5 with Harvard and Wharton students, presumably a smart group

 6 of kids, and they were offered a choice of S&P 500 index

 7 funds.

 8 And as a group, they failed to choose the least

 9 expensive of those identical options, and based their

 10 decisions on things like performance since inception, which,

 11 of course, has no bearing on the fund's forward-looking

 12 performance. That's going to be determined by exactly two

 13 things: the performance of the S&P; and the cost that they

 14 are paying to invest in those funds.

 15 So, greater transparency is a wonderful thing. I

 16 am concerned that it's not sufficient. I think the industry

 17 has to take the lead in helping folks to understand the

 18 impact of the fees that they pay, over the life of their

 19 investment.

 20 MR. SIRRI: Joe?

 21 MR. RUSSO: I surely agree with that. And might I

 22 say that mutual fund companies communicate with my clients

 23 all the time. They send all kinds of information. But they

 24 never speak to my clients, they never dialogue with my

 25 clients. That ongoing education that the client needs, in

 1 order to understand the relevance of a 12b-1 fee, or a

 2 management fee, or an administrative fee, or an operational

 3 fee -- you know, I'm all for transparency, I think we should

 4 have as much of it as possible, as much education as 

Page 126 
12b1transcript

 5 possible, so that there is a clear, concise understanding. 

6 That's a powerful incentive for the client to maintain a

 7 relationship with that mutual fund and that adviser.

 8 So, transparency is great, but it takes ongoing

 9 education in order to get the job actually done.

 10 MR. SIRRI: Brad?

 11 MR. BARBER: Yes, I just wanted to follow up. 

12 First of all, the study that Shannon was referring to was a

 13 study by Jim Wilcox in the "Journal of Business" in 2003. It

 14 was an experimental study of 50 subjects, and 46 of the 50

 15 failed to make a choice that was optimal for them, giving

 16 their holding period, which again suggests that folks need

 17 advice on making and navigating these choices.

 18 Even MBA students seem to need the advice after

 19 they graduate from MBA school, unfortunately.

 20 The other point I wanted to make is I completely

 21 agree that it is not just disclosure, it's two parts: 

22 transparency and effective communication. I think that

 23 latter part is often lost, because putting another disclosure

 24 on page 12 of the prospectus is not going to do any good in

 25 this arena. These costs need to be effectively communicated

 1 to investors in a way that is simple to understand.

 2 And I guess from my -- some would call it -- ivory

 3 tower of academe, what I would like to see is sort of a

 4 simple disclosure to investors, "This is the total amount you

 5 paid to fund managers last year, and of that amount, this

 6 amount went to sales and distribution, this amount went to

 7 advertising, this amount went to investment research, et 

Page 127 
12b1transcript

 8 cetera."

 9 There are allocation issues with that, which were

 10 raised before. But, for gosh sakes, corporations have

 11 accounting allocation issues every day and every year, in how

 12 they have to allocate their expenses among different items. 

13 So I don't think that's a necessarily overly onerous burden

 14 there.

 15 But at the end of the day, I would just like to see

 16 effective communication, along with the transparency.

 17 MR. SIRRI: John?

 18 MR. HILL: Yes, I think the issue of transparency

 19 is a key one, and disclosure. The problem is, so much

 20 disclosure gets made in the prospectus documents, and so some

 21 people feel the more disclosure you have, the less you have.

 22 To me, the best disclosure of any fee that an

 23 investor pays is what is charged to his or her account that

 24 year for that service that was performed. And you don't have

 25 to write any verbiage, you just have to say, "You paid a B1 share fee of X coming out of your account," and it's quite

 2 clear. Doesn't take any words.

 3 MR. SIRRI: So, given the way fee disclosure is,

 4 from the prospectus you've got two or three numbers, three or

 5 four numbers, that add together to a final fee.

 6 Do folks here believe that if, instead of taking

 7 that 100 basis points, 25 basis points, whatever it was, for

 8 distribution -- and instead, I think what you're saying, is I

 9 translate that to dollars, and put it -- not necessarily

 10 charting it, in terms of disclosure -- put dollar disclosure 

Page 128 
12b1transcript

 11 on the account statement, you think we would get a different

 12 outcome for people's purchase decisions? Mike says no.

 13 MR. SHARP: I don't think you will. I think what

 14 we were thinking, what we're talking about here, presumes

 15 that this is an inefficient market, that it's not a

 16 competitive market, and that people don't want to pay what

 17 they're paying.

 18 And I think if you put that dollar figure on

 19 somebody's confirmation, you put it on their monthly

 20 statement, you put it on their annual statements, you will

 21 see little to no change in behavior.

 22 MR. SIRRI: Is that a difficult thing to do today? 

23 Since you're in the business, is that a difficult thing to

 24 do, to get -- not to charge there, to get a dollar disclosure

 25 there, on an account statement? Is that hard?

 1 MR. SHARP: It is not hard to do, if you do it in

 2 the aggregate. To get to Brad's point about saying how much

 3 is research versus servicing versus advertising, that would

 4 not be easy to do, for all the reasons you can imagine. My

 5 business guys are probably cringing right now. It's probably

 6 a doable thing, it will probably cost money to do, but it is

 7 a doable thing.

 8 MR. SIRRI: But would you say this is one of the

 9 costs of increasing transparency of 12b-1, then?

 10 MR. SHARP: Yes, I think I would certainly advocate

 11 this is -- and if you looked at our confirmations right now,

 12 on other parts, we have a two or three-page mutual fund

 13 confirmation right now, for all of the different fees that 

Page 129 
12b1transcript

 14 are charged for clients.

 15 Now, we could tack on the next line, which would be

 16 12b-1 fees on your account base equals X dollars.

 17 MR. BARBER: Let me say, Michael, that I view

 18 myself as an economist, and I clearly see that there are

 19 costs to these disclosures. And the question is -- which I

 20 have no clue about -- is how large those costs are.

 21 And, clearly, that requires a lot of investigation,

 22 to see whether mandating these disclosures, or encouraging

 23 them, is sensible or not.

 24 MR. KEIL: Yes, it begs the question, would it

 25 change the outcomes if they had this information.

 1 MR. HILL: I think that's almost impossible to

 2 answer that question. That's kind of a metaphysical

 3 question.

 4 I think what it would do, though, is give trustees

 5 a great deal more comfort when they approve these plans, if

 6 there was clear information there on the investors'

 7 confirmation statement. And that would just -- it would be

 8 nice to have that comfort, something simple they could look

 9 at.

 10 MR. KEIL: My sense is that investors, who tend not

 11 to be very cost-sensitive, probably wouldn't change the

 12 decision. I think that they are more focused on service. 

13 Several studies have born that out, that they're willing to

 14 pay for service, they like service, it helps their decision,

 15 it gives them comfort. Investors certainly like comfort. 

16 And it's not likely to change. 

Page 130 
12b1transcript

 17 MR. SIRRI: We note that there have been a lot of

 18 proposals about how to package pricing for funds. One of the

 19 more recent ones is actually to go the other direction. 

20 We're talking about deconstruction. It's actually aggregated

 21 up into a unified fee, to have just one price that includes

 22 everything.

 23 When you listen to the language about it, some of

 24 the commentators have said it will be easier to understand,

 25 and folks don't necessarily -- investors don't necessarily

 1 need to understand what is in all of that -- call it 150

 2 basis points, whatever it is -- then there will just be one

 3 price, and that includes everything. Is that a sensible way

 4 to go, here?

 5 MR. SHARP: It depends. It depends on the client's

 6 choice. I say that not in jest. I mean, clients have

 7 spoken. We, right now, sell probably between 45 and just

 8 under 50 percent A shares. We sell the rest either in mainly

 9 C's or primary shares, and a very small amount of B shares.

 10 But we also have clients who want to go into a

 11 fee-based brokerage account. We have clients who want to go

 12 into wrap accounts. I think that the important thing is to

 13 keep investors in mind, and what it is they want from the

 14 account. And clients have spoken.

 15 Clients have the options right now. They see A's,

 16 they see B's, they see C's, they understand. We inundate

 17 them with information about what all this stuff is. And,

 18 quite honestly, it is a lot of information to get, which is

 19 why they need the advice. 

Page 131 
12b1transcript

 20 But I think clients have spoken, and I think that,

 21 if you went to one pricing, some clients would use it, and

 22 some clients would not.

 23 MR. ZIMMERMAN: The study that Brad and I both

 24 referred to, the title of the study is, "Why the Law of One

 25 Price Fails." It's because people don't have a strong enough

 1 grasp on the issue of expenses, in terms of the impact of

 2 those expenses, over the life of an investment.

 3 And to the extent that additional fees that are now

 4 currently broken out are baked into a single fee, I think

 5 that probably paves the way for additional confusion around

 6 what folks are paying for, and whether or not they are

 7 choosing to pay for those services that they may or may not

 8 be receiving.

 9 So it goes to the point that was made earlier. In

 10 addition to greater disclosure -- if disclosure is not going

 11 to be sufficient, because people -- there is plenty of

 12 disclosure now, there can always be more, and there should

 13 be -- but ongoing, effective communication about what the

 14 expenses entail, that would be a necessity, as well.

 15 MR. RUSSO: And could I just add to that, since

 16 we're talking about the disclosure, and educating the public

 17 so that they understand the real nature of these fees.

 18 We should add, supposedly, no-load mutual funds

 19 into these, to the conversations, because, as we all know,

 20 no-loads are full of loads, and they have administrative

 21 expenses, and operation expenses, and management expenses,

 22 and they may not have a 12b-1 fee -- or they may -- but 

Page 132 
12b1transcript

 23 they're full of loads.

 24 And so, I think we're all in agreement here, in one

 25 fashion or another, that we want to educate the public in

 1 such a fashion that they fully understand, and can make a

 2 valid decision, based upon that information.

 3 My sense is that an all-in-one fee may, indeed, be

 4 the answer, and may, indeed, drive prices to the lowest

 5 possible competitive level. And I would have to hire Brad to

 6 do a study on that to tell you for sure.

 7 MR. KEIL: I am going to take a little different

 8 perspective. I think that what the unified fee does is

 9 remove the benchmarking process of all the component pieces,

 10 so that the trustees don't have to -- or the adviser doesn't

 11 present information about the competitiveness of the services

 12 provided under the custodial contract and transfer agency, et

 13 cetera, et cetera, to the point where the board is satisfied

 14 that all those fees are priced reasonably, and the fund, in

 15 total, is priced reasonably, I think you lose that.

 16 MR. HILL: I think the notion of a unified fee has

 17 merit. I'm in the private equity business, and it seems to

 18 work, everybody seems to buy into it.

 19 But to me, it really suggests what we're hearing

 20 here is that there ought to be flexibility, there ought to be

 21 a variety of options. There ought to be choice. If some

 22 people want a unified fee, there ought to be that available. 

23 Some people want to pay over time, that ought to be

 24 available. If somebody wants to pay up front, that ought to

 25 be available. 

Page 133 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

The key is, when they're making that choice -- and 

I think when they're making that choice they need to know 

specifically what it costs. They don't do that now. 

MR. BARBER: So, let me ask you a question, Erik. 

When you say "unified fee," does that mean that there would 

be one fee disclosed, and all expenses would be wrapped under 

that fee? 

MR. SIRRI: That's the context. There would be one 

number. 

MR. BARBER: There would be one number. So, I 

guess the issue is, then, can you communicate to investors 

effectively what they're paying for the different services 

provided by a mutual fund? 

And so, I guess I'm not opposed to there being one 

fee -- in other words, wrap the 12b-1 into the one fee, or 

all the stuff into one fee, as long as the underlying 

services, or cost of those underlying services, are 

transparently and effectively communicated to investors. 

I think the issue, though, is mutual funds can 

compete on a lot of different dimensions. They can compete 

on service, they can compete on investment research, they can 

compete on price. 

And in order to compete on those dimensions, prices 

of each of those dimensions have to be clearly disclosed to 

investors, because some investors may choose high service, 

Page 134 
12b1transcript

 1 low investment research. Some may choose high service, high

 2 investment research. And unless they know what they're

 3 buying with a mutual fund, one fee may not communicate that

 4 to them.

 5 MR. SIRRI: Well, listening to what you're saying,

 6 there is something unusual about mutual funds, the mutual

 7 fund business. Because you have this security, the mutual

 8 fund. It sits there. And you have something that normally

 9 goes along with it, at least for a lot of purchases, which is

 10 advice.

 11 We have selected a regime where the pricing of the

 12 two is often bundled together. So you get one versus the

 13 other, and then you get a 12b-1, administrative fees packaged

 14 together.

 15 Is there any reason to believe it is efficient to

 16 package them together, whereas -- forget how you do it for a

 17 moment -- it is sensible to break them apart? Is there a

 18 reason why we should have those all rolled up together?

 19 MR. ZIMMERMAN: If you're talking about the

 20 efficient use of investor capital, I think the answer is

 21 clearly no, right? I mean, to the extent that people are

 22 paying an ongoing fee, and their investment results are worse

 23 as a result of that, then no, it's not an efficient use of

 24 their capital. Whether or not it makes sense on the business

 25 side is a completely separate question.

 1 MR. SHARP: Again, that answer presumes that the

 2 market is not efficient. It presumes that there is no

 3 competition in the mutual fund industry. And it presumes 

Page 135 
12b1transcript

 4 that if you do away with 12b-1 fees, you do away with that 25

 5 basis-point cost. And you don't.

 6 So, if it's not in the 12b-1 fee, it will show up

 7 in the management fee, it will show up in the administrative

 8 fees. And if efficiency means you're paying for what you're

 9 getting, I think there is efficiency now. And I think if you

 10 change to unified pricing, or to something else, you would

 11 pay pretty close to what you're paying right now.

 12 MR. SIRRI: We're obviously thinking hard about

 13 these kind of questions. As we grapple with sort of the

 14 status of how we pay for servicing and distribution, and the

 15 manner by which it's disclosed, what should be our objective,

 16 as the public policy makers here? How should we think about

 17 whether or not, based on outcome, we have done a good job?

 18 MR. HILL: I think the -- as I look at that issue,

 19 your objective ought to be to have a policy that, in effect,

 20 pays for services that investors need, but which does so in

 21 an efficient manner. And I'm talking about an economically

 22 efficient manner for the investor, not for business, if you

 23 will.

 24 And an economically efficient -- at least to pass

 25 the criteria on economic grounds, it's got to be one where

 1 there is full information. Otherwise, you're not getting an

 2 efficient decision, an efficient choice.

 3 Secondly, I think it's got to be fair. One of my

 4 biggest concerns with the B shares is that they're not

 5 fundamentally fair to all the investors in the individual

 6 funds. We have investors who have bought in on day 1 who are 

Page 136 
12b1transcript

 7 actually now subsidizing investors who bought in on day 350,

 8 depending on performance. So you get tremendous cost

 9 subsidies here that are unfair. And, again, that, to me,

 10 is a criteria of public policy: fairness.

 11 MR. SIRRI: But isn't that just the nature of the

 12 mutual part of a mutual fund?

 13 MR. HILL: Well, like I'm saying, if investors paid

 14 that fee up front, and paid it over time, he wouldn't be

 15 subsidized; he'd be aware of it anyway. It's the hidden

 16 nature of the subsidy, day in and day out, without them

 17 really understanding that subsidy -- it goes into hundreds of

 18 millions of dollars.

 19 MR. SHARP: You know, you had asked what you should

 20 do now. And I think it gets back to the earlier point that

 21 you made that I picked up on, is that we have to do what's

 22 right for investors. And I think acting just for the sake of

 23 acting makes no sense. Because no matter what we do, it's

 24 going to cost something, whether it's going to Brad's point

 25 of doing research, going to an account-based thing, any of

 1 that is -- account-based or doing research on this stuff,

 2 exactly what each facet of the fee is, is extremely

 3 expensive.

 4 I think this has been a wild success. When you

 5 look at 12b-1 fees, and you look at the way it's built into

 6 the system, when you look at what it's done for the industry,

 7 what it's done for investors, getting back, 25 years ago,

 8 only 6 percent of people invested in mutual funds, you now

 9 have 48 percent of the people investing in mutual funds, 

Page 137 
12b1transcript

 10 that's a good thing.

 11 And I think that we need to be real careful about

 12 what we do here, because acting just for the sake of acting

 13 makes no sense.

 14 MR. BARBER: I have to jump in. I have heard this

 15 throughout the day.

 16 As far as I know, there are no studies that link

 17 the 12b-1 fees to the growth of the mutual fund industry. 

18 And I think there is a lot of other conflating effects. For

 19 example, the movement from defined benefit plans to defined

 20 contribution plans probably comes first and foremost to my

 21 mind.

 22 That's speculation on my part, not backed by

 23 scientific evidence as well, but I think it's probably a

 24 better conjecture than that 12b-1 fees have led to the growth

 25 of the mutual fund industry.

 1 Let me also add that the 1990s witnessed the

 2 biggest bull market in history, and investors tend to chase

 3 performance with their asset allocations. So it wouldn't be

 4 too terribly surprising to me if that also had something to

 5 do with the growth of the mutual fund industry. I just had

 6 to throw that in.

 7 MR. SHARP: And I would agree completely, but I

 8 wouldn't ignore the fact that 12b-1 has made it easier for

 9 people to invest in mutual funds, whether it's doing away

 10 with what used to be an 8.5 percent front-end load, or giving

 11 people the option of A shares, B shares, or C shares, it's

 12 made it easier. 

Page 138 
12b1transcript

 13 MR. RUSSO: And the way that that charge comes out

 14 of a mutual fund is tax efficient. If -- there are

 15 unintended consequences if we make a change in this. And the

 16 first unintended consequence is going to be we're going to

 17 lose a tax preference item.

 18 Because if I have to charge my client 25 basis

 19 points, and send him a bill for that, that is not going to be

 20 deducted from his total return of the mutual fund, it's going

 21 to be a bill that he cannot deduct in his taxes, unless it

 22 exceeds 2 percent of his adjusted gross income, which it

 23 never will.

 24 And so, you lose a tax efficiency when you start

 25 meddling with the current structure.

 1 MR. SIRRI: John?

 2 MR. HILL: Yes, I think it's just not right to say

 3 that 12b-1 has done these wonderful things for the mutual

 4 fund industry. I think, clearly, the last 20, 25 years since

 5 we have had B shares, 12b-1, we have had an explosion in

 6 economic growth in this country, and tremendous creation of

 7 wealth that happened during this period.

 8 Secondly, you had the demographics of the Baby

 9 Boomers starting to retire, and people have generated these

 10 assets, they have to do something with it, the mutual fund

 11 industry was smart, to be there to help these people with

 12 their needs.

 13 But it wasn't 12b-1 that created the booming

 14 economy demographics, it really was other factors. And

 15 mutual funds just happen to be there. If we hadn't had B 

Page 139 
12b1transcript

 16 shares, they would have been buying A shares. They needed

 17 someplace to invest their money.

 18 MR. SIRRI: Jeff, let me ask you something. As I

 19 understand your business before -- your current

 20 business -- when you were at Lipper you provided data to the

 21 15(c) process, the process of creating the review of board

 22 materials. I presume you sat in on some board meetings.

 23 What do you think of the board review of the

 24 materials that support 12b-1 decisions? How do you think

 25 about that, the factors they consider, versus the practices

 1 you see out there? You must have seen a lot of that.

 2 MR. KEIL: I would have to echo what was said

 3 earlier, that it's a non-decision -- it's a necessity, it's a

 4 recoupment of outlays. It's a competitive posturing, meeting

 5 the standard payouts of the business, et cetera.

 6 At the risk of using an overused term, it's a bit

 7 of a rubber stamp, frankly. It's a necessity. It's not a,

 8 "Gee, let's do a real analysis, the correlation of the

 9 expenditures versus the benefits," it's, "No, we have to have

 10 it, it's a necessity, end of story."

 11 MR. SIRRI: When trustees -- in your experience,

 12 when trustees consider these things, are they thinking, "This

 13 is going to help the fund grow larger and pass on economies

 14 of scale?" Is that what they're thinking? Or are they

 15 thinking, "We've committed to these financing arrangements

 16 for distribution," or are they thinking, "This pays for

 17 servicing to shareholders, and we want that to happen as part

 18 of the product attribute?" 

Page 140 
12b1transcript

 19 MR. KEIL: They are thinking all of the above, and

 20 they have to think of all those component pieces, there is no

 21 way around it.

 22 What I don't think does exist, the

 23 disaggregation -- at least not that I have seen -- the

 24 disaggregation of all the different component pieces of the

 25 12b-1 fee, looking at those individually for correlations,

 1 let's say, of advertising, for example. I am not aware of

 2 that happening. Or maybe in very rare cases.

 3 MR. BARBER: I will say that there has been some

 4 study -- actually, my own study with Terry Odean and Lu

 5 Zheng -- about 12b-1 fees. And in that study -- it was

 6 published in the "Journal of Business" in 2005 -- we found

 7 that 12b-1 fees actually attract money, that flows tend to

 8 increase following 12b-1 fees, which makes sense, right?

 9 I mean, these 12b-1 fees partially are for sales

 10 and distribution. You charge the fees and you distribute

 11 them, but I think one of the issues that -- and let me be

 12 clear, that I am not laying any accusations, I am merely

 13 asking the question, which is: are these fees to promote the

 14 sale of the funds, or to service?

 15 And, to what extent are investors aware of those

 16 two buckets, the promotion and sales side of the 12b-1 fee,

 17 and the service side of the 12b-1 fee?

 18 MR. SIRRI: Shannon, you probably have the greatest

 19 contact with investors, day in and day out, and what they

 20 know. How would you describe what they understand about

 21 package of services they're paying for, what the various line 

Page 141 
12b1transcript

 22 items are on the prospectus, and whether they care, in fact?

 23 MR. ZIMMERMAN: In my experience, investors have

 24 lives, and so they don't spend a lot of time poring over

 25 prospectuses. Maybe the annual reports that are especially

 1 well written, they spend more quality time with.

 2 But in terms of drilling down, actually paying

 3 attention to the anatomy of an expense ratio, and

 4 understanding the various component parts of it, I'm not sure

 5 that that's sort of something they race home to do, to see if

 6 the prospectus has arrived at the mail box to figure out

 7 what's under the hood.

 8 I do think that good things have happened in recent

 9 history. People have become much more aware of the impact of

 10 fees. Look at the growth of the index fund industry, or the

 11 low-cost providers, like Fidelity and Vanguard. They have

 12 done a tremendous job of gathering assets, in large part

 13 because they have been able to offer low-cost solutions to

 14 practical investment problems.

 15 But in terms of this being a burning issue,

 16 unless -- except insofar as it affects the performance, the

 17 return that investors are earning or not earning as a result

 18 of the fees, I don't know that there is a great level of

 19 awareness, or even interest in that.

 20 MR. SIRRI: Thank you. Brad, you had mentioned

 21 earlier, when you were talking, I think you described

 22 American investors, I think, as a financially illiterate

 23 populous. I don't know whether that's right or not.

 24 But I was thinking back to the first panel, when 

Page 142 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 25 Kathie McGrath made reference to a point of sale document, 

which was some kind of a document that gets distributed when 

the mutual fund decision gets made, so that information 

passes at that point that would contain something -- at a 

minimum, say, pricing information. 

This might be an alternative to, say, account-level 

disclosure. Any sense of whether that would be effective at 

what you all are thinking about? I know there is differences 

of opinion, but is that a direction we should be thinking 

about, that is, forcing that information at the point of 

sale? 

MR. BARBER: Erik, I think that that's something 

worth exploring, and I think it's actually something that, if 

the Commission devotes some resources to -- and it wouldn't 

be exorbitant -- if you would get an experimental economist 

to run some of these surveys with the two, you might be able 

to ascertain whether those sorts of disclosures would make a 

difference. 

And, by the way, I'm not an experimental economist, 

so I'm not looking for work, here. You could get some 

indication of whether those sorts of disclosures would change 

outcomes in a positive way, again, referring back to the 

study that both Shannon and I talked about before, choices 

have not been optimal when they're put to folks. 

And so, the question is, if you provide clear 

disclosures about, "This is what you would pay with the A 

Page 143 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

shares, this is what you would pay with the C shares, given 

your holding period, this is what the present value of those 

costs are, what do you want to do," see if their outcomes 

would change, I think that would be worth pursuing and 

seeing. We don't know the answer to that question. 

MR. SHARP: I think you all now are in the middle 

of working with the Rand Corporation to do a study like that, 

or at least having that as part of the study. 

The one thing I would say is that if there is going 

to be point-of-sale disclosure, it can't be in writing, 

because it just won't work. And even oral disclosure at the 

point of sale, to the extent that Brad is talking about, 

clients will not want to hear it. 

MR. SIRRI: I want to be clear. What is it that 

clients wouldn't want to hear at the point -- let's say it's 

oral. What is it that they wouldn't want to hear at the 

point of sale? 

MR. SHARP: The level of disclosure that you have 

been talking about, with respect to, "Okay, you are buying an 

A share, you are buying a B share, you are buying a C share. 

The present value of the cash flows is so-and-so." That will 

not play well with clients. 

And that -- I can be disproved by the Rand 

Corporation when the time comes, but I think you will find 

that out. And I think, in fact, that one of the problems you

all had with the point of sale disclosure that you came out 

Page 144 

 1 
12b1transcript

 2 with before was it really sounded great, a lot of

 3 information, and for really financially savvy people.

 4 Fell flat on its face, because the people don't

 5 want to hear that kind of information. They want to buy

 6 advice, they want to buy guidance. And that's what they're

 7 doing.

 8 MR. RUSSO: I spent a week reading statistical

 9 summaries of these kind of modelings. And, frankly, I came

 10 away saying, "Nobody models the behavior of the client." 

11 This is not a zero sum game. You do certain things, you get

 12 certain responses.

 13 You want something -- you want to prohibit an

 14 event? Tax the heck out of it. You want to encourage it? 

15 Drop the tax on it. And the same thing goes with the fees

 16 that we're charging in these mutual funds.

 17 So, I question whether or not we can actually model

 18 a study that's well enough done so that we can come away and

 19 say, "We should structure it in this fashion or in this

 20 fashion." I think we should underscore the fact that it has

 21 been very successful in the manner and mode in which it is

 22 delivered to the clients today.

 23 MR. HILL: I guess the thing I struggle with is why

 24 mutual funds are in a unique category all by themselves, they

 25 don't need to have point of sale disclosure.

 1 When I buy a stock, I get a point of sale

 2 disclosure what the commission was. When I get my tax

 3 returns done, I get a point of sale disclosure of what they

 4 charged me to do my taxes, broken out between his own advice, 

Page 145 
12b1transcript

 5 his own time, and his printing press, if you will -- just a

 6 whole array of things I do in life, there is point of sale

 7 disclosure.

 8 But, for some reason, mutual funds are considered

 9 to be different, and it would be bad. It would be --

10 MR. SHARP: I'm not sure we're saying that.

 11 MR. HILL: You're saying disclosure problems.

 12 MR. SHARP: And if you look at -- I mean, that's

 13 another thing. We have spoken all about a lack of

 14 transparency with 12b-1 fees.

 15 I would ask all of you to look at the prospectus. 

16 There is enormous disclosure about exactly how many basis

 17 points are being paid on management fees, administrative

 18 fees, 12b-1 fees, and every other fee in the world.

 19 There is a ton of disclosure out there. Now, is it

 20 at the time of the sale, when I'm on the phone with a client? 

21 No, it is not.

 22 MR. HILL: And it's not by the client, it's by the

 23 fund.

 24 MR. RUSSO: It may be by the adviser, John. In

 25 fact, when you look at the multiple vehicles that advisers

 1 are putting in front of the client, insurance products -- try

 2 and get good disclosure out of insurance products, in terms

 3 of what expense is involved, and what return of the client is

 4 actually there.

 5 Less so with a variable annuity -- but very much in

 6 the same fashion, everybody agrees transparency and

 7 disclosure is a good thing. And that's why I think when we 

Page 146 
12b1transcript

 8 hit upon the unified pricing of these costs, to actually give

 9 somebody something that they can compare.

 10 Mike is probably right, in that we have an

 11 efficient market now, so it probably won't drive prices down,

 12 but it will sure let my client, with a high-school education,

 13 be able to look at that and say, "Hmmm, 150 basis points,

 14 that one is 175 basis points, so this one may be better."

 15 MR. BARBER: I doubt they will know what basis

 16 points are.

 17 MR. RUSSO: I will educate them, I promise.

 18 MR. SHARP: And just one other point is that

 19 financial advisors do give this kind of -- they just don't

 20 get into the level of detail we're talking about on this

 21 panel.

 22 Our guys literally have to -- when they're entering

 23 an order, they have to attest to the fact they have had these

 24 conversations with clients. Those conversations are followed

 25 up by our branch managers, not on a call-by-call basis, but

 1 on a sampling basis. We do this because it's the right thing

 2 for clients. It happens.

 3 MR. RUSSO: And one of the unintended consequences

 4 of not doing it in this fashion is that you have the stampede

 5 of 100,000 independent security professionals moving to the

 6 investment advisory arena, so that they can avoid a lot of

 7 the complexity, or continue their ongoing fee structure. And

 8 that provides not only additional costs, but a huge burden to

 9 the regulatory arena, I would think.

 10 MR. ZIMMERMAN: Just to ask a question of folks who 

Page 147 
12b1transcript

 11 are proponents of the 12b-1 fee as it stands now, or maybe

 12 only slightly modified.

 13 I feel like -- and I'm sure this is the case for

 14 everyone who is here -- that we're hearing the best case

 15 scenario for the way in which the 12b-1 fee is used.

 16 What about the dark side? I mean, to the extent

 17 that these fees incentivize people to put their clients in

 18 funds that may not be appropriate for them, when cheaper

 19 funds might be the better way to go, how do you speak to

 20 that? At least as a potential concern, and probably a

 21 practical one, as well.

 22 MR. KEIL: I think you hit on sort of why I support

 23 the point-of-sale disclosures. I think it should be clear to

 24 the clients where the conflicts of interest are, what the

 25 specific dollar amounts a financial advisor or intermediary

 1 gets for selling one product versus another product.

 2 And if he or she selects the product that is not

 3 the cheapest, but let's say one on the upper end of the

 4 scale, that some reasonable justification should go on for

 5 that -- the fund has better servicing, the fund has lower

 6 risk -- or good risk adjustments, or what have you.

 7 I think that's a necessary part of the process. 

8 And I think, understanding of course, that you can go crazy

 9 with the documentation on a point-of-sale disclosure if it's

 10 done in a written form -- and I think there needs to be a

 11 balance between oral and written, something reasonable on the

 12 record, but not overwhelming.

 13 MR. SHARP: But, again, this presumes it's not 

Page 148 
12b1transcript

 14 happening right now, and it is. The stuff you're talking

 15 about happens right now. There is disclosure at the time of

 16 sale, there are rules and regulations that are imposed on us

 17 on suitability that has to go to the exact issue of whether

 18 one fund is cheaper or more expensive than the other.

 19 My firm, a lot of firms in the industry, have

 20 gotten rapped for that. And because of that, there have been

 21 changes in practices. We are not operating in a vacuum. 

22 This is not the first discussion we have had about mutual

 23 funds and 12b-1 fees. Built into the sort of fabric of the

 24 industry are all the rules and regulations that apply right

 25 now. It works.

 1 MR. KEIL: I have no question that groups the size

 2 of Citigroup, and other ones of that magnitude, certainly get

 3 a lot more scrutiny than the rest of us. I think that the

 4 challenge is that you create a regulation not for the

 5 Citigroups of the world, but for some of the smaller groups,

 6 where this kind of thing isn't happening. And I think that's

 7 the issue.

 8 MR. RUSSO: Everybody who is registered with the

 9 National Association of Security Dealers is functioning under

 10 the same premise and the same guidelines on disclosure.

 11 And I daresay none of Michael's 17,000 brokers, nor

 12 none of my 81 brokers, has a client who expects you to work

 13 for nothing. They all expect to pay for this, and it's just

 14 a question of making it understandable to them.

 15 MR. SIRRI: But, Mike and Joe, in your support of

 16 12b-1 you pointed out that you give very clear disclosure to 

Page 149 
12b1transcript

 17 clients, either in writing, orally, and in all sorts of parts

 18 of the process.

 19 But if we asked the question the other way, and I

 20 went to your clients and said, "Do you pay for advice? Did

 21 you pay for distribution? How much did you pay?" Would they

 22 have a sense of that?

 23 MR. SHARP: I think they would know they were

 24 paying. Would they know how much was split between

 25 distribution and advice? No, I don't think they would know.

 1 I don't think they can tell you that, to be honest

 2 with you, because there is a fine line between distribution

 3 and servicing and advice. And I will be darned if I could

 4 figure it out. But they do know they're paying. They know

 5 they're paying.

 6 MR. SIRRI: Part of what we're dealing with here is

 7 whether or not it's important that investors

 8 understand -- whether it's beforehand -- and you made it

 9 clear to them beforehand; I think that's your point -- or

 10 after the fact, that they have a comprehension of the various

 11 bits, the management costs, the distribution/servicing costs,

 12 and so forth.

 13 Is it important that they comprehend those for

 14 their purposes?

 15 MR. SHARP: I think it's crucial that they be told. 

16 I think it's crucial, because it's good for investors, and

 17 it's good for us.

 18 MR. SIRRI: That's a different question.

 19 MR. SHARP: I know. But the fact of the matter is, 

Page 150 
12b1transcript

 20 it gets back to these MBA students. You know, there is a big

 21 difference between being financially savvy and financially

 22 illiterate. I don't think our clients are financially

 23 illiterate.

 24 In many cases, they are not financially savvy,

 25 which is why 70 percent of mutual fund investors go through

 1 intermediaries like us to do this. They are looking for

 2 advice, and they're looking to pay for that advice.

 3 So, will it help clients to see it? Yes. If we

 4 can do it in some way that we can put a dollar value on it,

 5 it's a doable thing. Will it make a difference? No, because

 6 I think the market is very efficient right now. And I don't

 7 think -- and if anything, if you take it the wrong way, it

 8 could -- it certainly won't drive prices down, and it could

 9 drive them up.

 10 MR. RUSSO: Another way to express that, Erik, is

 11 to say, yes, it's important to us that the client understand

 12 it, that it's fully disclosed. No, it's not important to the

 13 client.

 14 I shared with you over lunch the global positioning

 15 satellite system. That project was managed by a client of

 16 mine. He's a brilliant, brilliant guy, who cares not one

 17 twit what I am charging him for this service or that service,

 18 even though it's fully disclosed, even though I beg him to

 19 listen to me, as I make those full disclosures.

 20 The long and the short of it is he has a mutual

 21 trust relationship that spans 30 years, and he is not

 22 interested in reading the prospectus. 

Page 151 
12b1transcript

 23 MR. SHARP: And that mutual trust is backed up by

 24 arbitration and litigation and regulation. There is a system

 25 out there, and it works.

 1 MR. RUSSO: The audits that occur every year in the

 2 National Association of Security Dealer branches would be

 3 reduced to perhaps once every three to five years. That's

 4 one of your unintended consequences if you move this from the

 5 securities realm into the investment advisory realm.

 6 MR. SIRRI: Well, let me turn the question around

 7 then a little bit, and ask Brad and Shannon. If this is so

 8 important, this deconstructive sort of pricing and clear

 9 disclosure, then why don't we have it today?

 10 After all, there is nothing that stops people,

 11 stops companies, from breaking this down. There is nothing

 12 that stops a broker from disclosing this kind of information. 

13 They could invest in the systems. They might be expensive,

 14 but they could do it. And if this is such a great idea, they

 15 may garner assets and have a very successful business.

 16 So, I don't see anything that causes the market not

 17 to do this.

 18 MR. BARBER: Seach costs. Oh, you have written on

 19 this, Erik. So Erik Sirri and Peter Tufano wrote one of the

 20 first papers on search costs in the mutual fund industry. 

21 What do I mean by that?

 22 If you create a complex landscape for trying to

 23 figure out which mutual funds investors should be in, you can

 24 support an intermediary business that, essentially, solves

 25 that search problem for investors. So it's a very difficult 

Page 152 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

problem for an investor to come to, and solve that problem. 

And so, I think that's one of the reasons you don't 

see it now, is the intermediaries have no incentive to 

eliminate or minimize that search cost, because it supports 

their activities. I think that's the economic equilibrium 

that we might be in. That's speculation on my part. 

I think that -- will changing this, making 

transparent, effective communications change that landscape? 

I don't know. But I think it's movement in the right 

direction, to try to communicate these costs effectively to 

consumers. 

MR. ZIMMERMAN: And, again, just to sort of 

reiterate, I also think that greater transparency would be a 

movement in the right direction. 

I don't know, though -- in the same way that maybe 

we're not interested in the kind of enamel that our dentists 

use whenever they work on our teeth -- maybe when you look 

under the hood of an expense ratio, the various component 

parts, if they're broken out better, I'm not so sure that 

that's going to represent a competitive advantage for one 

mutual fund company over the other, given the level of 

interest that investors have. 

And one of the reasons they're going to mutual 

funds is for the sake of convenience. They do not have to do 

the kind of research that would have to be involved, 

Page 153 
12b1transcript

 1 necessarily, in investing in a particular stock.

 2 To the extent that they do do research, there are

 3 probably things that they are focused on that are more core

 4 to the investment side of it, the manager, who is the

 5 manager, what's his track record, what are the strategies --

6 how has the fund fared in that market, what are the risk

 7 measures? But the fee component, I think, is not going to be

 8 a big selling point.

 9 MR. HILL: Yes, I don't think the issue of cost is

 10 a real issue. When you think about a statement you get from

 11 your broker, or you get from your manager, or Citibank, they

 12 lay out all kinds of data, specific to your account, that you

 13 were charged that period. And at the end of the year, they

 14 give you a complete data run on your taxes, capital gains,

 15 income, et cetera.

 16 It cannot be that expensive, just to put a code in

 17 there that says, "And you paid this 12b-1 charge," trail

 18 charge or up-front charge. That's got to be simple. And

 19 when I look at the things these computer people are doing

 20 today on derivatives, if they can create those little

 21 monsters this is certainly a simple, cost-free case, I would

 22 think.

 23 MR. SHARP: Or, they could pay a lot more for

 24 derivatives.

 25 (Laughter.)

 1 MR. SIRRI: We look at the way we distribute funds

 2 today and the way they're priced, we have share classes that

 3 differ by distribution charge, fundamentally. And there are 

Page 154 
12b1transcript

 4 a lot of reasons for that. One of them, I think as we all

 5 know, is section 22(d) of the Investment Company Act, that is

 6 essentially the resale price maintenance structure.

 7 You know, we've been talking about 12b-1, but maybe

 8 we're talking about the wrong issue. Maybe we should, in

 9 fact, be talking about changing that aspect of the framework. 

10 That is, taking 22(d) away, and let brokers compete, on a

 11 broker-by-broker or adviser-by-adviser basis, for the

 12 distribution of fund shares.

 13 And then -- let's just go that way, and be very

 14 direct about it. Is that something -- are we focusing on the

 15 right problem, here?

 16 MR. SHARP: We've done that. Fee-based brokerage. 

17 And, not surprisingly, average fee-based brokerage fees are

 18 between 95 and 105 basis points. I don't think it's an

 19 accident that's similar to where 12b-1 fees are for

 20 deferred back-end load fees.

 21 MR. SIRRI: Could you just explain, in pricing, why

 22 you think that fits that model, for people who don't know?

 23 MR. SHARP: For those of you who don't know,

 24 fee-based brokerage is instead of paying a commission for

 25 your business -- this started back in the late 1990s, and may

 1 or may not be coming to an end -- the notion was to put

 2 clients and FAs on the same side of the table, to avoid

 3 situations in which FAs would have to trade the account in

 4 order to get paid. The notion was to provide fee-based

 5 brokerage, where you would get paid a percentage of

 6 what -- how many assets were in the account. 

Page 155 
12b1transcript

 7 And in the top five or six firms in the industry,

 8 there are about $300 billion worth of assets in those

 9 accounts, where the average fees are somewhere between 95 and

 10 105 basis points, where only an incremental part of that is

 11 paid for advice, because it is fee-based brokerage. That

 12 notion, I know, is open to question, in terms of the advice

 13 part of it.

 14 But the fact of the matter is, it's a brokerage

 15 account. You don't have the protection of being protected by

 16 the advisers, you're not dealing with a fiduciary, you're

 17 dealing with a broker. And those fees are roughly 100 basis

 18 points.

 19 And I think that part of the reason that that has

 20 grown, some people wanted that choice. They wanted the

 21 choice to go in and pay one fee, no matter what they did in

 22 the account, including for mutual funds.

 23 MR. SIRRI: And the fund shares sold through those

 24 accounts, are they -- what's the pricing on them? How are

 25 the --

1 MR. SHARP: No load. I'm sorry, that's what you

 2 were asking -- I missed it.

 3 MR. BARBER: Well, the other part of this that, you

 4 know -- and Shannon raised this earlier, and I guess it's

 5 something I would encourage the SEC to look at -- is the

 6 extent to which investors do end up in vehicles that perhaps

 7 were not appropriate for them. And I don't know to what

 8 extent you're able to look at that issue, but I think that

 9 that's one issue that there is not a lot of evidence out 

Page 156 
12b1transcript

 10 there on.

 11 And if what the industry claims is true, that there

 12 is not pushing of the investment vehicles to maximize the

 13 payments to the intermediaries, then you should see very

 14 little misplacement of investors. So one key element of this

 15 is whether that is widespread or trivial, or non-existent.

 16 MR. HILL: I think there is merit in your notion of

 17 22(d) and moving in that direction, because it would push

 18 everything to the client and the broker, in terms of costs

 19 and discussions.

 20 It would get boards out of these annual reviews,

 21 trying to make judgements about whether or not these fee

 22 costs are reasonable, and how do you ever know that -- maybe

 23 for some investors, not for others.

 24 It would get trustees out of trying to make

 25 decisions about whether or not the right investor bought the

 1 right funds or whether there are controls in place. These

 2 are just enormous problems.

 3 If you go the 22(d) route, it gets us out of that

 4 game all together, and I don't think the outcomes are going

 5 to be any worse. They might be better.

 6 MR. ATKINS: I wanted to sort of follow up on that,

 7 what Mr. Hill was just talking about. Since you're the only

 8 trustee on the panel, I don't want to necessarily pick on

 9 you.

 10 But earlier in the day, we talked about some of the

 11 factors built into 12b-1, whether they are still relevant

 12 today. And I just wanted, since you are voting on a 12b-1 

Page 157 
12b1transcript

 13 plan year in and year out at Putnam -- I assume you have one.

 14 MR. HILL: Obviously.

 15 MR. ATKINS: You know, do you find these factors

 16 still relevant? And if not, how do you analyze the 12b-1

 17 plan, from your perspective?

 18 MR. HILL: That's a fair question. I think that,

 19 by and large, the original rules are -- some still have

 20 validity, but a lot of them are outdated and outmoded.

 21 I think there is a broader set of issues and

 22 questions we asked today that are not on the original list,

 23 some are ones we devised, when we were trying to come up with

 24 our own criteria to try to determine what was reasonable and

 25 fair. How do we get at that answer?

 1 So, I think there is a need to update that list,

 2 and particularly with all the new options, platforms, and

 3 SMAs that you have to look at, it is outdated.

 4 MR. KEIL: Excuse me. The theme that kind of

 5 resonates through those is sort of the temporary phenomenon

 6 of 12b-1, and the reassessment of it on an annual basis,

 7 where I think that, really, that doesn't go on any longer.

 8 MR. HILL: Right.

 9 MR. ATKINS: And then one other just follow-up, I'm

 10 sorry, but your firm was sort of a poster child for scandals

 11 a few years ago, when you had a huge number of redemptions.

 12 MR. HILL: Right.

 13 MR. ATKINS: And I was just curious, with respect

 14 to some of these brokerage fees, 12b-1 or whatever, what your

 15 experience was in that you think you all benefitted by having 

Page 158 
12b1transcript

 16 this sort of program in effect. How did you make changes to

 17 rescue your firm?

 18 MR. HILL: Well, I'm not sure I can answer that. 

19 We really -- we've made a lot of changes to 12b-1 before we

 20 had two of our employees market-time their funds, which was

 21 the issue at Putnam. And we have taken hundreds of millions

 22 of dollars out of the 12b-1.

 23 It is a very profitable program, notwithstanding

 24 what we heard this morning, because if you look at it on its

 25 own, under the NASD rules, it's quite profitable.

 1 Now, to the extent that managers take money to

 2 spend on distribution and declare it unprofitable, that's

 3 their choice of how they're spending the profit from that

 4 activity. It has nothing to do with profitability of 12b-1.

 5 But we had taken steps just to take the profit out,

 6 because we looked at it as part of our annual fee discussions

 7 and negotiations about how much money we thought should be

 8 left at the manager.

 9 I don't -- I think the 12b-1 is operated pretty

 10 well there. We have even had discussions, and we have even

 11 had brokers come in and talk to us. We have gone out and

 12 visited brokers in their offices and around the country, in

 13 their home offices, to understand how they sell shares, to

 14 get comfort.

 15 So, I don't think that was a -- I thought the B

 16 shares operated fine, and it had nothing to do with these two

 17 portfolio managers who timed their funds.

 18 MR. SIRRI: Let me turn -- ask one last question, 

Page 159 
12b1transcript

 19 in terms of something that was raised in one of the earlier

 20 panels, I think the second panel. There was a point raised

 21 that having 12b-1 funds may make it easier for small, young

 22 funds to enter the business, that it levels off some of the

 23 competitive space.

 24 I wonder what folks thought of that, whether they

 25 thought that this was a pro-competitive measure, that having

 1 this sort of a structure was helpful, and in fact, did

 2 improve the competitive landscape, or whether, in fact, as

 3 sometimes is the case, you become -- which way -- how should

 4 we look at the pure competitive/funds entering the business

 5 space question, with regard to 12b-1?

 6 MR. KEIL: I think there is some validity to that

 7 argument. But at the same time, I think what does happen is

 8 that -- and was alluded to earlier -- you've got a -- you

 9 know, if it isn't in the form of a 12b-1 fee, distribution

 10 finds its way into the management fee, or there is some way

 11 to finance it some other way. It's a reality, period. But I

 12 think just the existence of the 12b-1 -- there is a little

 13 more flexibility in the model, and that's positive.

 14 Of course, there is also the question of sort of

 15 that bouying inefficient players in the market gives them a

 16 little extra resource to play with. But I think that if

 17 you're truly inefficient, you're a marginal player, you kill

 18 yourself.

 19 MR. ZIMMERMAN: Is the implication of that question

 20 maybe that 12b-1 could be modified in such a way that it

 21 would benefit funds that were still in base building mode? 

Page 160 
12b1transcript

 22 MR. SIRRI: It's possible. I mean, funds can do

 23 all sort of things. They could waive fees, they could do

 24 many things.

 25 MR. ZIMMERMAN: Right. I guess my position on

 1 12b-1 is probably pretty clear by now, but I guess I'm open

 2 to persuasion as to whether or not it could benefit in the

 3 form of greater competition, as funds are up and coming.

 4 Because -- and I know that we learned earlier today

 5 that the dwindling assets, net redemptions, that wasn't so

 6 much one of the motivating forces behind 12b-1. But to the

 7 extent that a fund can raise its asset base, and have more

 8 shares to distribute its cost across, that benefits

 9 shareholders in the form of a lower expense ratio.

 10 So, I guess I could see, if it was carved out

 11 carefully, maybe tied to a program with expense ratio

 12 reductions along the way -- but then that gets into a

 13 regulatory thicket that maybe we wouldn't want to try to

 14 navigate.

 15 MR. BARBER: I guess, from an economist's

 16 perspective, the question is whether there is any barrier to

 17 entry in the mutual fund industry, and whether you have to

 18 encourage entry through providing some sort of incentive, et

 19 cetera.

 20 And I guess I don't view there to be huge barriers

 21 to entry, given my sort of observation of the fund.

 22 MR. SHARP: I would agree with that. I don't think

 23 there is a barrier there. In fact, I think, quite to the

 24 contrary, entry is relatively easy. And the think that keeps 

Page 161 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 25 small or large fund players in is performance. 

MR. ATKINS: Just one point here, I guess my two 

cents would be that a huge barrier to entry would just be the 

huge costs of getting geared up to be able to comply with the 

rules. It is easy for those who are already established, but 

when you talk to folks who try to set up smaller funds, 

compliance costs are something we struggle with to maintain a 

balance. 

MR. BARBER: If there are economies of scale, maybe 

you shouldn't encourage for there to be small funds 

neccesarily. In other words, if compliance is an important 

part of the landscape, then maybe it's not efficient to have 

the smaller funds. There are still plenty of folks out there 

who are willing to finance a competitor if it's a profitable 

industry. 

MR. ATKINS: Well, everybody starts small, and if 

you want innovation, you'd probably take exception to that. 

MR. SIRRI: I think we're getting to that time. I 

would like to go give all the panel an opportunity for some 

closing remarks. And I would ask you -- feel free to say 

what you will, but I would like to ask you if you would 

answer one question along the way. 

And the question is this, that, given our structure 

of how we pay for distribution and services through 12b-1, 

are investors, through that method of pricing, getting the 

right package of services? Or, if you want to flip it 

Page 162 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

around, are they paying the right amount for the package of 

services they're getting? And if not, which way should we 

go? 

MR. BARBER: I wasn't sure which end you were 

starting on. 

So, I guess let me just iterate a couple of things 

that I have said throughout the discussion this afternoon. 

First and foremost, I think the expenses should be 

transparent, and effectively communicated. I think the point 

has been made that many of these expenses are, to some 

degree, disclosed in the prospectus. But I don't think they 

are effectively communicated. 

And I think some discussion of that -- for example, 

what sort of point of sale document might be the most 

effective communication -- is worth noting. 

To reiterate some of the points I have made today, 

surveys indicate that 80 percent of investors are not aware 

of the expenses they pay for their largest mutual fund 

holdings, so there are clearly many who do not know what they 

are paying. 

The experimental evidence that both Shannon and I 

have talked about suggests that investors don't necessarily 

make the right choices when choosing among funds. 

And let me also add there is the curious example of 

index funds. So, Ed Elton, Marty Gruber, and Jeff Busse, in

2004, did a study of index funds. And there were 52 S&P 500 

Page 163 

 1 
12b1transcript

 2 index funds that they looked at, from 1996 to 2001. Some of

 3 these funds charged front-end loads, many charged 12b-1 fees. 

4 And the expense ratios on these index funds, which were all

 5 tagged to the S&P 500, scored greater than 99 percent for the

 6 statisticians in the audience.

 7 But their expense ratios ranged from 10 basis

 8 points to 1.35 percentage points per year. The expense

 9 ratios explained all of the variation in performance. And

 10 the question is, how can those vehicles survive in a

 11 competitive landscape?

 12 And I think part of the answer that you have to

 13 think about is whether some investors are being put into the

 14 high-expense funds inappropriately.

 15 Another solution might be that they are put there

 16 because they get high levels of service, when, in fact, the

 17 study looked at that issue, and there was not a lot of

 18 evidence of variation in service.

 19 And so, I think it is important -- this study, I

 20 think, sort of concludes that the index funds investors hold

 21 have higher 12b-1 fees, higher loads, and higher expenses in

 22 the best portfolios, and funds used almost all 12b-1 fees and

 23 loads and part of the expense ratio to reward sales persons

 24 and market funds. Apparently, this marketing effort produces

 25 the desired effect.

 1 I think there is some question as to whether that

 2 sort of push in the industry leads folks to a bad outcome. 

3 We have no evidence on that. All we can observe is what the

 4 landscape looks like. And I think that the incentives right 

Page 164 
12b1transcript

 5 now are sort of, "Here are the fee structures," and I would

 6 like to see that made more transparent, to reduce the search

 7 costs, so investors know precisely what they're getting.

 8 MR. HILL: Yes, I guess the -- just a few points. 

9 One, I think it needs to be said and resaid that investors

 10 buy performance first, they buy performance second, they buy

 11 performance third. And when performance is not good, they

 12 look at their expenses. That is when expenses become an

 13 issue.

 14 Having said that, I think that, given the costs of

 15 these services, which I think are necessary -- I think we do

 16 varying degrees of service, some a little, some a lot -- I

 17 think it's important that we break out the costs of various

 18 options, what the costs are to an investor when they buy a

 19 fund, just like when they buy a stock, or any other service. 

20 I don't find differences here that justify a separate

 21 category for mutual funds.

 22 They still need this product. So, to me, the best

 23 way to go is to try to push this towards the broker and the

 24 investor, give the broker and the investor lots of

 25 flexibility on how this service gets paid for.

 1 I actually have a lot more confidence in investors

 2 making smart decisions about cost, anyway. Nobody can make a

 3 good decision about performance. It always turns out to be

 4 not quite as good a fund as it was the last three years.

 5 But I think the more you can push it there, and

 6 have it clearly laid out, the better off we will be. And we

 7 will also get trustees out of trying to make judgments that 

Page 165 
12b1transcript

 8 are metaphyscially impossible.

 9 MR. KEIL: I think a number of recommendations, or

 10 considerations, I think, should be undertaken.

 11 In contrast to Mr. Uek and Mr. Haaga's comments

 12 earlier, I think I would like to see the distribution

 13 fees -- and I mean the loads and the asset-based sales

 14 charges and the service fees -- charged at the account level,

 15 rather than at the fund level through the 12b-1 payments. I

 16 think it's clear for the shareholder. I think it enables a

 17 more direct total expense ratio comparison.

 18 And I think -- and I'm sure it happens in very rare

 19 cases, but there is the potential to have a service fee

 20 charged at the fund level, and also some level of

 21 all-inclusive or wrap fee at the account level, where you've

 22 got a double counting, potentially.

 23 Now, I can't say I know how often it happens, but

 24 closing that loophole may be useful.

 25 MR. RUSSO: What's your answer on the tax angle?

 1 MR. KEIL: I'm not a tax accountant. I know that

 2 that's been one case that has been made, and I also heard

 3 from people that the estimates have been overblown. And I

 4 don't know, honestly. I would rather not speak to that.

 5 I think I would like to echo the sentiment about

 6 not using the term "12b-1." I think 12b-1 is very confusing. 

7 It sounds like some kind of plastic explosive, or something,

 8 so let's get rid of that.

 9 Obviously, modernizing the board considerations, I

 10 think that's useful. 

Page 166 
12b1transcript

 11 I think one thing that has never been done -- and I

 12 understand that, originally, when the rule was crafted, the

 13 ultimate flexibility was sort of the goal, that we didn't

 14 want to box people in to having different kinds of

 15 distribution models, let them sort of be creative, and kind

 16 of figure out where they want to go, what worked and what

 17 didn't work, et cetera, and if someone got out of line, you

 18 know, we would slap them, but up to that point, let them be

 19 creative.

 20 I think acceptable distribution expenditures should

 21 be defined in some way, shape, or form, or say what's not a

 22 distribution expenditure. I think that would be useful. I

 23 think the language that had driven me crazy for years is

 24 "Payment is an intended result of the sale of fund shares."

 25 Well, that is the goal of the mutual fund

 1 companies, to sell shares. I mean, anything from beefing up

 2 the portfolio management staff, to a number of things, are

 3 designed to do that. But they don't fall in the realm of

 4 distribution, per se.

 5 Another sort of loophole I think needs to be

 6 closed, or needs to be brought under purview of 12b-1 is

 7 there is a number of funds that have what I referred to as

 8 the non-12b-1 service plan. Basically, it smells like, looks

 9 like, operates like a servicing plan under 12b-1, but it's

 10 outside of 12b-1. I think that should be brought under the

 11 rule, and sort of defined more clearly.

 12 The other piece that happens also is there is a

 13 level of personalized servicing that goes on under the guise 

Page 167 
12b1transcript

 14 of the transfer agency fees under sub-transfer agency. 

15 Again, that needs to be defined clearly, so that needs to be

 16 under the 12b-1 purview, as well.

 17 One other issue -- and it was brought up in the

 18 paper I sponsored a number of years ago -- and that is the

 19 issue of compensation versus reimbursement plans. I think

 20 that's the key here. And some guidance, as far as what's

 21 acceptable, as far as how those operate, might be useful, as

 22 well.

 23 And maybe one last point. I think with any

 24 modification of a rule, it's unlikely you're going to get it

 25 perfect. No offense intended, obviously, but a regular

 1 review of the rule, henceforth -- assuming, of course, it's

 2 modified -- is certainly useful.

 3 MR. RUSSO: Without sounding terribly corny, and

 4 without advocating this position 100 percent, "If it ain't

 5 broke, don't fix it." And that has some relevance, given the

 6 fact that this has been a very successful way of delivering

 7 not only the investment vehicle, but also a level of service

 8 that is tough to quantify.

 9 This panel is called, "Cost and Benefits." Well,

 10 costs can be generated pretty reasonably, accurately, through

 11 the kind of studies that my colleagues have undertaken. So

 12 we have a good handle on what the costs are.

 13 The benefits, on the other hand, are much more

 14 esoteric, and perhaps far greater -- just a short list is in

 15 the investment optimization that goes on in the relationship

 16 between the adviser and the client, reducing the turnover of 

Page 168 
12b1transcript

 17 mutual funds, believe it or not, telling a client when a

 18 market is down, that they should not be selling their funds. 

19 As silly as that sounds, folks, that happens all the time. 

20 And maintaining those clients in those positions is in their

 21 best interests. It's also in the best interest of the fund.

 22 Managing the expectations of clients, also in the

 23 best interest of the client, the best interest of the fund. 

24 Reallocating the resources through life. You meet annually

 25 with a client, it's unlikely that there are no changes in

 1 that client's life every year. Something has changed.

 2 There is more of them, there is less of them, their

 3 health is better, their health is worse, they are retiring,

 4 something is changing. And these investment packages need to

 5 change with them. The only way we can do that effectively is

 6 with a one-on-one relationship.

 7 There is also tax preparation that goes on, and

 8 sometimes it's simply supplying all the data to a

 9 professional tax preparer. Other times, there is tax

 10 preparation and filing that is happening, all on the basis

 11 not of a fee that is being charged, but on the 12b-1 fee that

 12 is being accumulated by that investment professional over the

 13 year.

 14 And in answer to the question that you posed, Erik,

 15 is this a right package for the client, and the answer is yes

 16 and no.

 17 And, again, I call our attention to the fact that

 18 on no-load funds that are full of loads, have no investment

 19 counsel other than what they're reading in a prospectus. And 

Page 169 
12b1transcript

 20 it's sad, for me, to believe that the small clients, the most

 21 vulnerable, will be reduced to reading a prospectus, and

 22 trying to make heads or tails out of that for their

 23 investment counsel.

 24 So, clearly, this system has worked. And whatever

 25 minor changes are made to it in order to encourage

 1 transparency are good, decent efforts that should be

 2 undertaken. But any major alterations I think would result

 3 in unintended consequences that we would all regret.

 4 MR. SIRRI: Mike?

 5 MR. SHARP: Yes. On behalf of Citigroup and Smith

 6 Barney, I want to thank the commissioners and Chairman Cox

 7 and Erik and Buddy for having me here. We very much

 8 appreciate that.

 9 I think I am a lot more positive than people are

 10 about this. You know, we think it's commendable that the

 11 Commission is look at this right now, and deciding about

 12 whether there are any things that need to be done with 12b-1

 13 fees.

 14 But I think, just to sort of strike the same note I

 15 struck at the beginning and in the middle, don't lose sight

 16 of investors, and don't lose sight of investors' interests. 

17 We think 12b-1 serves those interests.

 18 When the Commission adopted 12b-1 in 1980, it

 19 talked about the fact that there would be a continuous

 20 evolution of the way distribution would work, and the way

 21 12b-1 would work. And we have seen that evolution, and we

 22 have seen it work. 

Page 170 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 23 You know, the rule has facilitated a downward

 24 pressure, both on loads and fund expenses. And on the fund

 25 expenses side, because the intermediaries can do this better 

across a larger client base, with respect to integrated 

distribution services, and they can do it in a way that is 

more efficient than if the funds paid for it on their own, 

and certainly if clients paid for it on their own. 

The rule has also helped fund companies offer a 

menu of no-load, contingent deferred sales loads, and 

front-end load funds, to give clients more choices. And it 

has worked. And clients have spoken, they have demonstrated 

a preference, and not only for the professional adviser 

working through the array of funds that are out there -- and 

we sell close to about 100 fund families, and up to 3,000 

funds -- but also with respect to the servicing that goes on 

after they buy the mutual fund. 

And as I mentioned earlier, it is -- when you look 

at the mutual fund industry back in 1980, we were looking at 

front-end loads of 8.5 percent. And right now, I think the 

highest is about 5.75 percent on front-end loads, and the 

lowest is about 4.75. But it's not only the front-end loads. 

It's mutual funds expenses, in general. 

Back then, expenses were about 232 basis points, 

230 basis points. And they're more than half lower now, down 

to 107 basis points. And I think that 12b-1 has worked. 

Now, is 12b-1 responsible for all that? Of course not. But 

it has facilitated all of that. And I think that we need to 

be very careful in how we change it now. 

Page 171 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

And I think, also, that we need to be careful about 

the question about eliminating 12b-1 fees. I am not an 

economist, I don't even experiment as one, but I think that 

we need to be careful here. Because if we repeal 12b-1 fees, 

there is nothing that I have ever seen, heard, or sensed that 

says that fees are going to go down. I don't think they 

will. 

I think that if you go to an account basis for 

services, and advice that people pay, there is mass 

bargaining power out there right now with 12b-1 fees that 

gets capped by the NASD. You lose that mass bargaining 

power, and you lose that cap, and I am convinced that the 

small investors will be paying more than they're paying now. 

I'm just convinced of that. 

And there is that part of the mutualization. 

That's why they're called mutual funds. And I think we can't 

lose sight of that. We can't forget the investor. 

But I also think we should be a little bit more 

self-congratulatory, in particular, the Commission. I think 

that this experiment started 27 years ago. There has been 

scrutiny on it over the years, and I think there should be 

continued scrutiny. I think now that scrutiny will result in 

better communication on disclosure, or whether it's giving 

fund board members the ability to make an easier decision, 

rather than being locked into a 27-year-old set of factors 

Page 172 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

that people aren't sure what to do with. 

But I think we should not lose sight of the fact 

that 12b-1 has been a success. Tweak it, make it slightly 

better, but don't throw the baby out with the bath water. 

MR. SIRRI: Shannon -- the last word. 

MR. ZIMMERMAN: I'd also like to thank the 

commission and my fellow panelists, too. I don't necessarily 

agree with everyone. I have learned a lot about the industry 

point of view, as well. My mind has not changed, however. 

And just to illustrate why that's the case, I want 

to take you back to the distinction that we made earlier 

between customer and product, and investor and investment 

vehicle, and then ask a question. 

In what way is a mutual fund not like a toaster 

oven, right? A toaster oven, the more you pay, the more 

bells and whistles you receive. Unlike any other product 

under the sun, a mutual fund does not work in that way. The 

fee is a feature of the fund, itself. And to the extent that 

the fee is higher, the product, which are the investment 

returns, are necessarily worse, right? 

And so, I think that is a distinction, and it gets 

papered over when we regard mutual funds as products, rather 

than investment vehicles. And that sets aside the whole 

question of the services, the important services, that lots 

of folks provide.

 1 What I hope it does is it foregrounds the way in

 2 which those services can be paid for. So, that's the first

 3 point I would like to make. 

Page 173 
12b1transcript

 4 The second is I think that, to the extent that a

 5 12b-1 fee incentivizes folks to put clients into particular

 6 funds, and it fuels industry asset bloat, because it pays for

 7 marketing and distribution of those funds, the fees are

 8 particularly odious, because they ask shareholders to oversee

 9 the process by which their investment becomes worse.

 10 Again, just to go back to the point that I made

 11 earlier, as a fund's asset base grows, one of two things

 12 tends to happen. If it's a large cap fund, it morphs over

 13 time into an expensive index fund, and if it's a small cap

 14 fund, the manager's ability to pursue the strategy that they

 15 have had success with is impeded.

 16 And so, if 12b-1 fees are behind the problem of

 17 asset growth, then that's another problem.

 18 And then, we really didn't speak -- we sort of

 19 touched on this, but we didn't delve into it quite that

 20 deeply. I am concerned to know -- to pick up on Brad's

 21 point -- whether or not the financial incentives that exist

 22 for folks to put their clients into pricier funds that have

 23 12b-1 fee versus cheaper funds that could serve their

 24 interest better, what kind of effect that has, in terms of

 25 the investment performance that those folks receive over

 1 time?

 2 So, as the Commission continues to look at these

 3 questions -- and they do so with the needs of individual

 4 investors, front and center -- I hope that those are some of

 5 the issues that you will consider, as well. Thanks.

 6 CHAIRMAN COX: Well, thank you to every member of 

Page 174 
12b1transcript

 7 our panel, and, Erik, to you as moderator. This, like the

 8 preceding two panels, and I expect our next and last one, was

 9 exceptionally illuminating.

 10 You bring, each of you, a very significant bit of

 11 wisdom and perspective, and so on, that necessarily none of

 12 us can have here, and collectively, you've really done us a

 13 great service. So I want to thank you for the extraordinary

 14 amount of time and the wisdom that you bring to it,

 15 accumulated over many, many years, and, hopefully, your

 16 continued commitment to help us work on these problems.

 17 MR. SIRRI: I just want to mention that we will

 18 have a 15-minute break, after which we will come back for our

 19 final panel on the options we have going forward. Thank you.

 20 (Applause.)

 21 (A brief recess was taken.)

 22 PANEL FOUR -- LOOKING AHEAD: WHAT ARE OUR OPTIONS?

 23 MR. DONOHUE: The fourth panel of the day. Well,

 24 we certainly have had an interesting day, having heard from a

 25 very experienced, diverse group of individuals about the

 1 origin of Rule 12b-1, its current uses, and its costs and

 2 benefits. Now, for this final panel, I will be asking them

 3 to discuss what should be done now.

 4 We have a very distinguished panel, so let me

 5 introduce them. Barbara Roper is the Director of Investor

 6 Protection for the Consumer Federation of America, where she

 7 has worked for some 20 years. She is the leading

 8 spokesperson on investor protection issues, and has served on

 9 a number of boards and committees. She is a graduate of 

Page 175 
12b1transcript

 10 Princeton University.

 11 Mark Fetting is a Senior Vice President for Legg

 12 Mason, where he is responsible for the mutual fund and

 13 managed account businesses throughout the world. Mark is

 14 also on the executive committee, the board of governors of

 15 the Investment Company Institute, and is a director of Legg

 16 Mason and the Royce Funds. He holds an undergraduate degree

 17 from Wharton, and an MBA from Harvard.

 18 Don Phillips is a Managing Director of Morningstar

 19 and is responsible for corporate strategy, research, and

 20 corporate communications. Don joined Morningstar in 1986, as

 21 the firm's first mutual fund analyst, and soon became editor

 22 of its flagship publication, "Morningstar Mutual Funds." He

 23 holds a bachelor's degree from the University of Texas, and a

 24 master's degree from the University of Chicago.

 25 Dick Phillips is a Senior Partner at K&L Gates,

 1 where he concentrates his practice in securities regulation,

 2 particularly investment management, broker-dealer, and SEC

 3 enforcement. Dick has a long and distinguished career, which

 4 includes various positions at the SEC, and is the recipient

 5 of the William O. Douglas award in 2001. This award was

 6 given by the SEC Alumni Association for contributions to the

 7 development of securities law, and service to the financial

 8 and SEC communities over the years. Dick is a graduate of

 9 Columbia University and Yale Law School.

 10 And Avi Nachmany is a Co-Founder of Strategic

 11 Insight, a firm founded 21 years ago, as an investment

 12 management industry think tank and data resource. Avi guides 

Page 176 
12b1transcript

 13 the research and consulting areas, and contributes to the

 14 firm's technologies, including their SIM Fund-mutual fund

 15 databases. Avi holds an MBA from NYU's Stern School of

 16 Business.

 17 I want to thank the panelists who are here. I am

 18 Buddy Donohue, and I am the Director of the Division of

 19 Investment Management. Now, let's get started. Our job is

 20 to pull this all together, guys and ladies, so let's get at

 21 it.

 22 Barbara, why don't we start with you? We have

 23 heard a lot today about 12b-1, and why it's good for

 24 investors. But we really haven't had much from the investor

 25 perspective, and that's what you do for a living. So why

 1 don't you give us a little bit of help here.

 2 Do investors understand 12b-1s? Do they know what

 3 they are? Do they have a sense about them, and does it

 4 matter?

 5 MS. ROPER: Thank you. We have never tested,

 6 specifically on knowledge of 12b-1 fees, so I won't start

 7 there. We do know they don't know what loads are, so I

 8 suspect 12b-1 fees are even farther down the list of what

 9 they know and don't know.

 10 There have been some things said about what

 11 investors want and don't want today, and a lot of them are

 12 true. Clearly, investors want advice. We did a survey that

 13 looked at mutual fund investors, purchase practices and

 14 information preferences, and the channels through which they

 15 purchase. 

Page 177 
12b1transcript

 16 And, of course, their desire for advice is

 17 demonstrated not just by the fact that they choose to make

 18 their purchases outside of retirement plans through a variety

 19 of different kinds of investment professionals, but when you

 20 ask them about how they want to interact with that investment

 21 professional, what they tell you -- over a quarter of them,

 22 28 percent say -- they rely exclusively on the

 23 recommendations that they get from that professional. They

 24 don't look at a single other piece of information.

 25 And then, you have another -- I think it's 36

 1 percent -- who say that they rely very heavily on that

 2 recommendation, but they looked at something. They don't

 3 like prospectuses, particularly in this distribution channel. 

4 They have not only low positives, but high negatives, in

 5 terms of something that they value, or considered important

 6 in their investment decision.

 7 And we had done -- when we started this survey, we

 8 started by looking at what the experts said investors should

 9 know when they purchased mutual funds. And we found almost

 10 universal agreement -- whether you're looking at regulators,

 11 investor advocates, personal finance writers, industry --

12 when you look at what they think investors should know when

 13 they make that purchase.

 14 And then, we asked investors what they wanted to

 15 know. Very high on the list of what every expert says

 16 investors should know is they should have an understanding of

 17 the fees they pay.

 18 When you look within this particular distribution 

Page 178 
12b1transcript

 19 channel of those who purchase through a professional, you

 20 have a majority who say that the fee was at least somewhat

 21 important to them. But you have 45 percent who don't even

 22 rank it as "somewhat important."

 23 And I think that's important in this context,

 24 because if you're trying to convey something to mutual fund

 25 investors about the costs that they pay, the fees that they

 1 pay, you're overcoming a certain resistance to having that

 2 information. You are providing that in a context where many

 3 of them really don't make an investment choice, in the sense

 4 that we conceive of an investment choice.

 5 They are not weighing factors. They are not

 6 carefully reading disclosure documents. There is a wealth of

 7 information available to mutual fund investors. Much of it

 8 is presented in very innovative ways that makes it quite

 9 accessible. Much of it isn't, but for someone who is looking

 10 for it, it's there. They are not using it.

 11 So you have a real challenge, when you're conveying

 12 something as complex as this, and that constrains your

 13 ability to rely on disclosure, or sort of -- I think,

 14 fundamentally transforms the way you use disclosure in this

 15 area.

 16 You know, I heard the previous panelist talking

 17 about, "We inundate them with information." Well, yes, we

 18 do. And we do not present it to them either at a time when

 19 it is useful to them in making their decision, or in a form

 20 that they are likely to comprehend. It's not simplified.

 21 I actually think less is more. I think what mutual 

Page 179 
12b1transcript

 22 fund investors need to know in this area is what they're

 23 paying for the operation of the fund. Maybe they need to

 24 know what they're paying for the services of the broker in

 25 providing them that fund. And those are two very different

 1 things.

 2 And they don't need to know how it all breaks down,

 3 and what's the transfer agent getting, and what's for this

 4 kind of fee and that kind of fee. That should be available

 5 for the, maybe, one percent of mutual fund investors who

 6 might want that level of detail -- I say they all work for

 7 Don. But it's not something that we need to focus on when

 8 we're talking about how we work effectively in this area for

 9 the average investor.

 10 One of the things that I have sort of been

 11 frustrated about, both as I have listened to the conversation

 12 today -- although I found it quite educational -- and as I

 13 prepared for these remarks, is we have heard over and over

 14 again, or you read over and over again, about how investors

 15 have spoken, investors have chosen, the client has spoken,

 16 this is a response to investor desire, I'm sorry, I don't buy

 17 that.

 18 It does not follow that it doesn't provide a good

 19 option for investors. The ability to pay for the services

 20 you receive from a broker in some kind of incremental payment

 21 is probably a good thing for investors. It certainly is not

 22 anything we're interested in getting rid of.

 23 But the idea that that exists because investors

 24 demanded it, I think, is a myth. It exists because it 

Page 180 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 25 provided a distribution channel for brokers, one that was an 

alternative and has many positive characteristics, but also 

makes the costs quite non-transparent. And I don't think 

that is a coincidence. 

The growth and use of these funds, at a time when 

there was a lot of press around no-load funds, I think there 

was a reason brokers wanted to receive their compensation for 

the services they provided in a way that did not allow 

investors to easily put a price tag on those services. And I 

think that is the glaring weakness of 12b-1 fees -- that it 

puts something into the shadows and distorts the other 

decisions that are made. 

Also, I don't think investors make a choice about 

which share class, typically, is in their best interest. 

They rely on the broker to make that decision for them. And 

up until the regulators intervened, there is significant 

evidence that it wasn't always made with their interests 

foremost. 

And even if we take steps to really improve the 

transparency around 12b-1 things, I think there is a very 

real possibility that the -- we will still have to rely 

heavily on brokers to make those decisions for investors, and 

we will have to rely on regulators to ensure that those 

decisions are made with investors' interests in mind, unless 

we're prepared to fundamentally re-evaluate the way we 

compensate brokers for the services they provide to 

Page 181 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

investors. 

MR. DONOHUE: Barbara, thank you. That was very, 

very helpful. 

Mark, one of the points that Barbara just made, do 

you feel like the costs that are really broker costs, have 

been wrapped by you, and now you wear them, you're 

responsible for them, but they're really the costs for the 

broker? 

MR. FETTING: Well, I think that what we're talking 

about today is the mutual fund and mutual fund investing. 

And I think, before I can answer that, I would like to lay 

out what I think is essential about the success of mutual 

fund investing. It combines three basic services. 

It starts with portfolio management, which is the 

starting engine of the business as several have said -- it 

delivers performance, which is the essential ingredient of 

success. That is at the portfolio level. 

The next level of service is the client service, 

advice, -- it enables what Don has studied, in terms of fee 

performance realization, so that you're not just getting it 

at the portfolio level. The individual shareholder is 

getting it in their own facts and circumstances. 

And then, of course, the third level of service is 

the administrative piece, ranging from fund accounting to 

custody, et cetera. So we're talking about, and for those of

us who have been in the business long enough, the old 

Page 182 

 1 
12b1transcript

 2 Weisenberger kind of compilation, right? Professional

 3 management; client service; and administrative efficiency.

 4 Those three things, combined, deliver mutual fund

 5 investing, which, today, is where America invests. Almost

 6 100 million shareholders, over 50 million households, 50

 7 percent, are now investing. So, I think we should appreciate

 8 the simple combination has been very good for saving and

 9 working and investing America. And to try to split out any

 10 one, more than another, has its peril.

 11 So, to go specifically to your question, Buddy, and

 12 to build on what Barbara was talking about, I think it is

 13 important that we recognize that the individual shareholder

 14 typically -- I think it's four out of five now -- use some

 15 sort of an intermediary. And they have chosen to do that. 

16 And that intermediary assists them in matching up that

 17 portfolio to their specific facts and circumstances.

 18 I am one of five. My father ran a retail jewelry

 19 business. The first thing he did for us, because a customer

 20 of his happened to be a financial advisor -- in those days

 21 I'm not even sure what they call them, it was certainly a

 22 broker, or a client representative, or a customer -- whatever

 23 it was, that customer of my father's jewelry business said,

 24 "You ought to do this, Jack."

 25 And my father didn't really understand, as much of

 1 your research has shown, how it happened, but he felt

 2 confidence in this individual, agreed with the

 3 recommendations, set up the accounts, and it enabled us, as

 4 children, to go on to schools that he was very proud of. And 

Page 183 
12b1transcript

 5 I think there are a lot of investors that we serve, like my

 6 father.

 7 There are a lot of investors who are busy in their

 8 other lives, whose accounts, whether it's $50,000, or

 9 $100,000 or $200,000 -- they're not necessarily $2 million or

 10 $20 million -- but they really do benefit from this

 11 combination of services.

 12 And so, my simple question is what's wrong with

 13 combining services, when it delivers an efficient,

 14 value-added benefit to clients that are willing to pay for

 15 it?

 16 MR. DONOHUE: Thank you, Mark. Question for the

 17 group. Toss-up. We have heard a lot today about how 12b-1

 18 has really helped facilitate competition.

 19 My question, observation, is if you go within a

 20 particular channel, 12b-1 fees tend to be uniform, and tend

 21 to be at the NASD maximums. And while you may have -- on one

 22 level, you do have choices of share classes. On another

 23 level, there doesn't seem to be much competition with respect

 24 to, ultimately, what those fees are.

 25 What's the view of the panel? Is 12b-1

 1 facilitating competition? Is it impeding competition? Or,

 2 maybe neither of the above? Dick?

 3 MR. RICHARD PHILLIPS: I think that you have to

 4 separate, for purposes of analysis, 12b-1 fees into two

 5 parts.

 6 First, is the 25 basis-point service fee; second is

 7 the 75 basis-point distribution fee, which according to the 

Page 184 
12b1transcript

 8 NASD, years ago was the economic equivalent of the front-end

 9 load. The 25 basis-point distribution fee has been

 10 effectively used by no-load funds to gain entry into the

 11 mutual fund marketplaces, and other channels. And in that

 12 sense, it has enabled those funds to compete for a broader

 13 segment of the investing population.

 14 In terms of the rest of the 12b-1 fee, the

 15 equivalent of the front-end load, I don't think it has

 16 fostered competition. If anything, it has restrained

 17 competition in two ways.

 18 Number one, it does not have the transparency of

 19 the front-end load. The investor who puts in $10,000 into a

 20 class A share knows that he is going to pay $525 to $575 for

 21 the services of an intermediary. That investor gets dollars

 22 and cents transparency.

 23 That same investor, if the money is put into a

 24 12b-1 class, gets basis point transparency. That's not the

 25 equivalent. And, therefore, to the extent it inhibits

 1 transparency of charges, it inhibits price competition.

 2 It inhibits price competition in another way. 

3 Because it's paid at the fund level, and because the amount

 4 of the 12b-1 fee is really set by the intermediaries -- not

 5 by the fund, not by the underwriter, not by the directors --

6 it restrains competition, insofar as the sales charge is

 7 concerned.

 8 Unlike individual securities, there is no price

 9 competition in terms of the commission, if you will, or the

 10 counterpart of the commission. You cannot go to E*Trade, or 

Page 185 
12b1transcript

 11 another discount broker, and get a deal on a load fund that

 12 is any different than any other full-service broker.

 13 So, in effect, the 75 basis-point distribution fee

 14 paid at the fund level is a restraint on competition in two

 15 ways: relative lack of transparency and inability to bargain

 16 for it-- to select a low-cost broker if you don't want a full

 17 service and get a lower sales charge.

 18 MS. ROPER: I would say that I think the answer is

 19 both. I mean, there are clearly aspects of 12b-1 fees that

 20 have promoted competition: providing mechanisms for fund

 21 participation in retirement plans and supermarkets transforms

 22 the marketplace and creates a different kind of delivery

 23 mechanism that is a form of competition.

 24 I would say that 12b-1 fees have in common with the

 25 entire sort of product-based system for how we compensate

 1 brokers is that they foster reverse competition, constrained

 2 by regulatory limits. And that funds, like other investment

 3 vehicles, compete to be sold, rather than competing to be

 4 bought.

 5 It's not clear to me that if you -- and I think

 6 there is a very good case for decoupling broker compensation

 7 from investment vehicles. You know, one of the things that I

 8 worry about, frankly, if we do that, is I think there is a

 9 very real likelihood that prices come down for big accounts

 10 and go up for small accounts. And so, as an advocate for

 11 retail, and average retail investors, I have to be concerned

 12 about that.

 13 But on a pure market-based question, I think there 

Page 186 
12b1transcript

 14 is no doubt that the way we choose to compensate for the

 15 services we receive from brokers protects those services from

 16 competition.

 17 MR. FETTING: Yes, I would like to say on the

 18 competition, though, that it's really not -- if the economic

 19 benefit is a combination of investing, servicing, and

 20 administrative efficiency, then the competition shouldn't be

 21 on the pricing of one single element. And I don't think

 22 clients think of it that way.

 23 I think the competition should be on the net return

 24 delivered to that client, through their facts and

 25 circumstances. And if the cost of getting that service

 1 enables them to get more of the return realization over the

 2 course of their investing cycle, then I think we would all

 3 say -- and I think research has shown -- that that is valued.

 4 MR. DON PHILLIPS: I would like to build on what

 5 Mark said. I think it's very helpful to break down the cost

 6 of a mutual fund into those buckets that Mark used, the

 7 portfolio management; client service and advice; and

 8 administrative costs. And the issue I have with 12b-1 fees

 9 is that it really doesn't help you get costs into those

 10 buckets.

 11 As was said earlier today, people were talking

 12 about the different uses that they use 12b-1 fees for. And

 13 some of the things that were thrown out -- it's an ongoing

 14 fee to the advisers who sell funds; also it's the spread load

 15 transaction fee, the offset on internal marketing costs, the

 16 phone, the advertising, the web site. Well, all of those 

Page 187 
12b1transcript

 17 things would seem to fit under that client service and advice

 18 bucket.

 19 But then, also thrown out was paying for

 20 supermarkets, and paying for 401(k) plan administrators. And

 21 it seems to me that those are administrative costs. And

 22 that's the problem I have with 12b-1 fees, is I think it

 23 confuses the issue. I think it's almost as if you had your

 24 own personal budget, and you invented something you called

 25 37Q fees, that included part of your housing budget, and also

 1 part of your entertainment budget, but it didn't include all

 2 of either.

 3 And yet, every time you sat down to look at your

 4 household budget, you said, "Well, let's think about our 37Q

 5 fees." Well, it doesn't make any sense. You break it down

 6 into more economic buckets, as opposed to buckets that are a

 7 reflection of the historical or legal basis for their being

 8 charged.

 9 And that's the way I would like to see the fund

 10 disclosure go, to mimic what happens with public companies. 

11 You know, if you or I were to buy shares in a business, we

 12 would ask for some basic cost accounting, and we would say,

 13 "What went into cost of goods sold, what went into sales and

 14 marketing, and what went into general and administrative," it

 15 would be very basic.

 16 And in the fund industry, that breaks down into

 17 exactly the buckets that Mark has proposed: portfolio

 18 management; cost of goods sold; client service and

 19 advice would be sales and marketing; and then administrative 

Page 188 
12b1transcript

 20 would be the G&A part.

 21 Today, though, it takes a huge amount of financial

 22 gymnastics to try to get mutual fund costs into those three

 23 buckets. As was volunteered by two fund companies earlier

 24 today, the total amount of what they are charging for what

 25 they consider to be 12b-1-like fees exceeds the 12b-1 fee

 1 that they charge.

 2 In many cases, if you're paying a 40 basis points

 3 fee on a supermarket, clearly you can't pay for those fees

 4 just out of your 12b-1 fee, it has to come out of the

 5 management fee. So, some of what the client sees in the

 6 current breakdown of costs that they see as management fee is

 7 really going to sales and marketing.

 8 You also have the case of soft dollars where

 9 something that clearly would be a management fee is not even

 10 in the expense accounting. And I think if the Commission

 11 could clear this up, and just get those costs into those

 12 three buckets, that would do investors a world of good, and

 13 would do a lot to promote competition, because then you could

 14 look and see, with two different funds, how have they

 15 allocated your dollars, the dollars that flow through to the

 16 fund, into these three basic services.

 17 And then you could decide, do you favor a firm that

 18 is spending more on client services, or more on investment

 19 management. And you could also have some debate over are

 20 some groups inefficient, in the aggregate amount that they're

 21 paying for administrative costs, relative to others. That, I

 22 think, is what would inspire competition. 

Page 189 
12b1transcript

 23 MR. NACHMANY: Let me take it for a couple of

 24 minutes. First, I disagree with the original premise that

 25 there is homogenity in this pricing, and how it works. We

 1 had two broker-dealers today, and one of them, level-load,

 2 fee-based is 60 percent of retail sales, and the other one, A

 3 share, is the majority of the fund sales. So, clearly, there

 4 is even when you look at very similar organizations.

 5 But the way I look at this issue is other

 6 marketplace forces -- because at the end, we are very

 7 confused about this issue. But to some extent, the question

 8 is, are the marketplace forces trying to fix all those places

 9 that we have been confused, or perceived to be ultimately

 10 wrong for the investor?

 11 And I will just show you a couple of places that

 12 were not discussed today. B shares is where most of the

 13 anxiety around 12b-1 fees has been. And clearly some of that

 14 came out today. B shares today are, maybe, three percent of

 15 sales for brokers. It's a category that is in the process of

 16 self-regulation, losing about 20 percent of its assets due to

 17 net redemptions in each of the last 3 years.

 18 And from a practical perspective, it's no longer an

 19 issue, it's no longer a problem to try to fix. We talked a

 20 little bit about front-end loads and 22(d). The discussion

 21 that we have with an organization, 80 to 85 percent of A

 22 shares today are sold at the NAV. Ultimately, the business

 23 has transitioned to fee-based pricing everywhere you look.

 24 There are many other subtle changes in the

 25 business. More and more of the business is done through 

Page 190 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

platforms where funds are aggregated. And in some of those 

platforms, there are expectations to shift from A shares, 

which generally have 25 basis points, to institutional share 

classes. So we use that. 

We had this discussion from Schwab, that Schwab has 

two main platforms. One is called NTF -- no translation fee 

-- and one is called transaction fee. Usually, in a 

transaction fee, they are funds that are less expensive, and 

have no 12b-1 fees. The transaction fee piece of Schwab, to 

my knowledge, is going much faster than the others. 

So, the marketplace is working to figure out those 

things that we all have been confused about. And to me, 

trying to find a different way to fix that problem that the 

marketplace is not yet addressing -- is not clear what will 

be the outcome of that. 

MR. DONOHUE: Dick, you made a comment before that 

I would like to follow up on where you pointed to the 

position that directors are in now, where they effectively 

are price takers, not price determinants of 12b-1. 

And as I was preparing for the roundtable, I went 

back and read all of the Commission releases, and it was 

quite clear that the Commission relied -- was relying quite 

heavily on directors, particularly independent directors, to 

have a role, and a very crucial role, in determining when, 

where, to what extent 12b-1 fees will be used. 

Page 191 
12b1transcript

 1 You fast forward now 27 years, and you hear from

 2 many, including many members on boards, that it's the

 3 marketplace that is determining that, not the directors. And

 4 that directors are in a position of really being unable to

 5 fulfill the role, I think, that had been envisioned for

 6 directors, back when the rule had first been adopted -- is

 7 that something that the Commission should be concerned about

 8 at this point?

 9 MR. RICHARD PHILLIPS: With all due respect to the

 10 historians on the first panel, I don't think the Commission

 11 envisioned that 12b-1 would be so widely used as a substitute

 12 for the front-end load.

 13 And the Commission factors that directors should

 14 consider reflects the fact that they did not have that

 15 vision. They viewed 12b-1, if you look at the factors, as

 16 something that would be temporary and limited, a subsidy, if

 17 you will, to funds that need help in their distribution

 18 system.

 19 That is not the way 12b-1 is used today. It's used

 20 for two purposes. Number one, to pay for various kinds of

 21 services, including no-load funds, services on the

 22 marketplaces, services on pension fund platforms. It's used

 23 to incentivize salesmen to follow up on customers, and

 24 maintain a relationship. That's the function of the 25

 25 basis-point service fee.

 1 The rest of it, the 75 basis-point distribution

 2 fee, is used as a substitute for the front-end load. And

 3 that price, as well as the price of all intermediary services 

Page 192 
12b1transcript

 4 in the 12b-1 area, is set by the intermediaries.

 5 And if there is one thing the Commission should do,

 6 that I think, above all else, cries out for doing, is to

 7 reform the role of directors, not only with respect to 12b-1,

 8 but with respect to oversight of the distribution system. As

 9 the Commission's more recent enforcement proceedings show,

 10 distribution is a source of tension and conflict within the

 11 fund industry. And it's been the source of more enforcement

 12 action in recent years than any other area of fund

 13 operations.

 14 And it calls for directors' oversight of the entire

 15 distribution system, an understanding of how funds are

 16 distributed, what kind of money goes into the distribution,

 17 where does it come from. No one here, for example, this

 18 entire day, has mentioned revenue sharing, a very important

 19 component of the financing of the distribution of fund

 20 shares.

 21 Directors should understand how distribution is

 22 financed, where it comes from, the manager or its affiliates,

 23 the fund, or the shareholder. Directors should understand

 24 who gets it, how much they get, what are the conflicts. 

25 Okay?

 1 And 12b-1 is just a small piece of that

 2 understanding. And 12b-1, in terms of the role of directors,

 3 ought to be converted into a duty of oversight with respect

 4 to distribution, not with respect to simply the small piece

 5 of distribution that funds pay.

 6 And so, I urge the Commission to take a good look 

Page 193 
12b1transcript

 7 at the role of directors, in connection with the distribution

 8 function, and be realistic, in terms of recognizing that, A,

 9 distribution is necessary and inherent to the operation and

 10 development of the mutual fund, complex of the mutual fund

 11 industry and of each mutual fund.

 12 It's in the interest of the shareholders, because a

 13 fund that doesn't keep pace with its market is not going to

 14 be able to retain and recruit the talent that it needs to

 15 maintain good performance, both in operations and in

 16 investment performance.

 17 And directors have a responsibility to understand

 18 the operations of distribution systems, the financing of it,

 19 and to make a judgement whether or not the manager is

 20 devoting sufficient resources to distribution, and whether or

 21 not there are conflicts in the distribution system that need

 22 monitoring and oversight by the directors. And that is how

 23 the duty of directors ought to be reformed, in terms of

 24 12b-1 -- much broader than it is today.

 25 MR. FETTING: I would like to build on that, if I

 1 can, because the working group that we formed at the ICI,

 2 which included independent directors -- and we have a working

 3 paper on our site -- really tried to get exactly at Avi's and

 4 Dick's, Don's, Barbara's comments.

 5 This sounds like a sound byte issue, but it's not. 

6 This is a very complicated issue, because of the pervasive

 7 use of 12b-1, beyond what the original intention was. So,

 8 let's go through kind of the things that have come up today.

 9 Retirement investors, which is a big chunk of that 

Page 194 
12b1transcript

 10 50 million households. Almost 40 percent of those plans use

 11 12b-1s in one form or another, to kind of deliver the benefit

 12 of retirement investing, in one form or another.

 13 The individual investor, which is still very

 14 important -- and that 75 basis points is actually a minority

 15 in the total dollars, because of what Avi said, which

 16 is -- what is it, Avi, 80 to 85 percent of A shares are NAV,

 17 right? So that means they're only getting the 25, not the

 18 75, et cetera.

 19 So, as the Commission looks at this, we totally

 20 support the notion of looking at its current use, and

 21 marrying good board oversight with good disclosure, relative

 22 to its current use, in such a way that it continues to be a

 23 good benefit.

 24 Yes, there should be some changes, absolutely

 25 should be some changes in disclosure, in board oversight. 

1 But it being a fundamental part of delivering good service,

 2 which is part of the kind of trinity, if you will, of value

 3 that is delivered, I think is important.

 4 So, I really think this -- I really feel good

 5 about, that at the end of the day, we're coming to,

 6 hopefully, it's not a sound byte issue. It's a complicated

 7 issue, with multi-factors because of its usage, and we ought

 8 to look at it, accordingly.

 9 MR. DONOHUE: Mark, the day is not over yet.

 10 (Laughter.)

 11 MR. DONOHUE: Barbara, how do you feel about

 12 disclosure as the solution? 

Page 195 
12b1transcript

 13 MS. ROPER: Well, I mean, obviously, we're in favor

 14 of improved disclosure. But, as I said, I think you need to

 15 think creatively about when that happens and how that

 16 happens. It's not necessarily about more information. It

 17 can be about simpler presentation of information, or

 18 different information.

 19 I don't have a lot of confidence that, even if we

 20 really get the disclosures just right, a lot of investors

 21 will make the use of it that we would like to see them do.

 22 And the other thing I think, I have a fair amount

 23 of confidence that if we get the disclosures just right, and

 24 really bring some of these broker compensation costs out into

 25 the open, that they will shift into a less transparent form. 

1 As Dick was saying, revenue-sharing payments, for example.

 2 If you bring certain things out into the open and

 3 leave certain things hidden, or relatively hidden, you're

 4 creating an incentive to shift costs into a place where they

 5 can be hidden.

 6 I also have a concern -- and perhaps it's unusual

 7 for this to be brought up by the investor advocate, rather

 8 than some of the industry people -- but by dealing with this

 9 as a mutual fund issue, by dealing with this as a 12b-1 fee

 10 issue, or a mutual fund issue, instead of a broker

 11 compensation issue, sort of more holistically, you run the

 12 risk that you make mutual funds less attractive to sell. And

 13 I think that would be a very bad thing.

 14 I think it is very important that we do a better

 15 job around the entire issue of broker compensation questions. 

Page 196 
12b1transcript

 16 But I don't think that is a product-specific issue.

 17 And, obviously mutual funds have, in some ways,

 18 been well served by the distribution services that have been

 19 provided by broker-dealers. But there are other ways in

 20 which they have been very badly served.

 21 What we refer to as mutual fund scandals in recent

 22 years, some of them are mutual fund scandals, the timing,

 23 market timing. A lot of them are broker-dealer sales abuse

 24 scandals. And they get classed as mutual fund scandals,

 25 because we have made this linkage between the product and the

 1 provider. I understand why the brokers would want to hang on

 2 to the star of mutual funds, and use that as the way that

 3 they represent themselves to the public.

 4 But I do think there is -- when you tie these two

 5 things together, mutual funds have, in some cases, been

 6 sullied by that relationship. And I think compensation is

 7 almost always at the heart of those issues, when that has

 8 been the case.

 9 MR. NACHMANY: Yes, I want to touch just quickly on

 10 this issue of disclosure and confusion, just a couple of

 11 points, and maybe the other side.

 12 As I was preparing for this exercise the last few

 13 days, I tried one thing, I went to Morningstar.com and tried

 14 to figure out how complicated it is to figure out what's the

 15 expense structure of a fund. How long will it take me? It's

 16 four clicks. It's four clicks. Morningstar has done a

 17 terrific job. Four clicks.

 18 On the top of the page is the 12-month fees, then 

Page 197 
12b1transcript

 19 the whole breakdown the maximum sales load, the redemption

 20 fees, the maximum fees, and the cost projection for 3, 5, and

 21 10 years. It's four clicks for every fund. So, is this hard

 22 to understand? Yes, it is. But there is so much disclosure,

 23 and it's there.

 24 Just on a point of confusion, and I think it came

 25 up a lot today, I think most investors -- and something I did

 1 not fully understand until last week -- what is the "mutual"

 2 in mutual fund? What is the mutual in mutual fund? Because,

 3 when you think about this, those small investors, the 50, 60,

 4 70 percent of investment accounts that we have, are small. 

5 Almost everything in a mutual fund for those small investors,

 6 they are being subsidized by large investors. That's the

 7 "mutual" in mutual funds.

 8 Investment management fees are subsidized,

 9 shareholder servicing fees are subsidized. And sometimes,

 10 the 12b-1 thing is merged into that. Very small investors

 11 are somewhat subsidized by the very large investor. That's

 12 the deal that we have made here, to create a product that has

 13 cross-subsidization everywhere.

 14 And the 12b-1 is just one aspect of that. And just

 15 focusing on that, saying it's not always perfect, the product

 16 is not perfect. But, clearly, it has been accepted very,

 17 very well, despite its imperfections.

 18 MR. RICHARD PHILLIPS: You know, I question some of

 19 what Avi says -- and I do so hesitantly -- because I think

 20 you have got to separate the 25 basis-point service fee from

 21 the 75 basis-point sales compensation fee, or broker's 

Page 198 
12b1transcript

 22 compensation fee. And the two things are very different.

 23 I think it would be foolhardy, on the basis of the

 24 information that the Commission has today, to mess with that

 25 25 basis-point service fee. It's used in too many different

 1 ways for too many worthwhile purposes. No-load funds use it

 2 to gain access to the marketplace, to retirement fund

 3 platforms. It serves -- it should serve as an incentive for

 4 salesmen who sell class A shares and class B shares.

 5 Before the Commission passes judgement, maybe it

 6 ought to find out whether, in fact, the 25 basis-point

 7 service fee in class A is working somewhat as intended. Are

 8 there many letter writers like the one that was highlighted

 9 earlier today, or is that an isolated incident?

 10 Is there something that the NASD and/or the

 11 Commission can do, A, to find out whether there is a problem

 12 there, in that the service fee is not working as intended, to

 13 provide continuing service to shareholders, or is that an

 14 isolated case?

 15 Is there something that the NASD and the Commission

 16 can do to make sure that any laggards among the brokerage

 17 community are properly reminded of their responsibility to

 18 work for that 25 basis-point service fee?

 19 The 75 basis-point substitute for the front-end

 20 load, on the other hand, is pure sales compensation. And

 21 there is no reason why that shouldn't be made as transparent

 22 as the front-end load, and no reason why you can't introduce

 23 some modicum of price competition at the broker level for

 24 those investors who don't want servicing, who prefer dealing 

Page 199 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 25 with a discount broker, as they do in the case of individual 

securities. 

So, I would separate the two. The 25 basis-point 

service fee, I would recognize it as a very important factor 

in the maintenance and development of the fund industry in 

many different ways. Indeed, I would almost regard it as a 

necessary cost to the open-end structure of the mutual fund 

industry. 

The 75 basis-point sales load substitute is also a 

necessary cost for those investors who want that kind of 

service. But I think it ought to be made more transparent, 

as to what they're paying for. And that's a dollars and 

cents disclosure. 

MR. NACHMANY: The 75 basis-point on B shares is 

finished, because B shares are not selling anymore. It's 2 

percent of assets going away, and not a need to focus on that 

anymore, and the 75 basis-point level of funds, just very 

clearly articulated, is a fee-based, very well accepted 

substitution to other ways to pay fee-based. 

And, incidentally, all the other ways are generally 

higher in costs than the level load. So I think the 

marketplace has sort of clearly --

MR. RICHARD PHILLIPS: Why are we ignoring C 

shares? Don't C shares have a salesman's compensation 

component, as well as a servicing component? Indeed, I would 

hope that C shares provide more servicing, more advice than, 

Page 200 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

say, a B or an A share, because after all, over the term of a 

longer-term investment, the broker gets better compensation 

for it. And, in return, the broker ought to have incentive 

to give better service. 

But I would not ignore C shares. I don't think B 

shares is the only issue. Moreover, B shares is suffering 

from the problems of suitability exposed by the more recent 

NASD enforcement actions. And in five years, they may be 

back. 

MR. FETTING: Let's probe this issue. Because, to 

me, it's kind of an extension of choice, which the industry 

has been able to deliver, partially due to the structure of 

the funds, partially due to what 12b-1 allows. 

But if you think about today, the investor that 

doesn't want to go through an intermediary is currently doing 

that, whether it's through Schwab, dealing directly with the 

fund complex that is largely traditional no-load; through 

their retirement plan, where they're getting it at pretty low 

value, in terms of cost and efficiency, et cetera. 

But there still is a large group of investors that 

want to take advantage of advice. They're willing to pay for 

it. Now, if we were to say that the funds shouldn't do 

that -- assume you improve disclosure, and the funds 

should -- then what they're going to do is they're going to 

go to other places, as exists right now.

One of the fastest growing segments of the mutual 

Page 201 

 1 
12b1transcript

 2 fund business right now, are mutual fund wrap programs. And

 3 the brokers tend to charge a higher fee than what is embedded

 4 in the fund. They have that choice right now, they're

 5 pursuing it. They're pursuing it, presumably, because

 6 they're being disclosed at the account level that it's being

 7 charged, et cetera, et cetera.

 8 So, here again, if you look at the widespread

 9 choices that are available, if the fund really does deliver

 10 an efficient approach -- we improve the disclosure, we

 11 improve the board oversight and the factors -- isn't that

 12 progress, while still allowing multiple choice, across the

 13 board?

 14 MR. RICHARD PHILLIPS: I think we should allow

 15 multiple choice, but I would hope that a wrap share program,

 16 for most investors, gives them more service and more

 17 investment management or advice than they get from A shares

 18 or B shares. If they pay more for it, they should get more

 19 service.

 20 And I assume that, on the whole, investors are

 21 rational in that respect, as long as they know what they're

 22 paying for. And in the case of wrap programs, I think, by

 23 and large, they do know.

 24 MR. FETTING: And therein lies the mission of the

 25 SEC, to protect all investors. The average account size of a

 1 wrap program is $250,000. The average account size of a

 2 mutual fund program is $20,000. So, if we get the right

 3 disclosure in a more efficient format to a mutual fund

 4 structure, isn't that beneficial to this larger, 

Page 202 
12b1transcript

 5 smaller-balance investor?

 6 MR. NACHMANY: Mark? $336,000.

 7 MR. DONOHUE: Thank you.

 8 MS. ROPER: Can I just say? I don't understand why

 9 mutual fund companies have to dictate my choices for getting

 10 broker-dealer services. And, in fact, I have a multitude of

 11 choices for getting advice -- whether it's from asset

 12 management, fee-only financial planner, fee and commission

 13 financial planner -- all of the various different mechanisms

 14 for charging for brokers that do not have to go away, just

 15 because we stopped running those fees through the products

 16 themselves.

 17 And so, I don't think it's an automatic assumption

 18 that the choice diminishes if you stop choosing to compensate

 19 through this mechanism.

 20 The other thing I would just like to point out,

 21 having listened to today's discussion, this advice we're

 22 getting doesn't sound remotely like anything I would call

 23 solely incidental to product sales. And these fees sound a

 24 lot like special compensation for advice.

 25 And I am just suggesting that, in light of the

 1 recent court decision, it is an interesting discussion.

 2 MR. DONOHUE: Well, Dick, you broke up the two

 3 components of the 12b-1 fees. And let's go a little bit with

 4 that, let's talk about them a little differently. And we

 5 will take service fees and put them to the side for a moment.

 6 And for a moment, let's not try and come up with

 7 hypotheticals about what would happen to fees if they were 

Page 203 
12b1transcript

 8 externalized. The one thing that kept fees constrained

 9 inside the funds was not because the fund companies -- Mark,

 10 it wasn't because your firm kept them down -- it's because

 11 the NASD kept them down. And the NASD regulates brokers. 

12 So, we will put that aside for a moment.

 13 How do people feel about externalizing the 75 basis

 14 points? In other words, say that that's not really a fund's

 15 responsibility, to collect a load on behalf of the broker

 16 -- what if you wanted some competition to take place -- and

 17 put aside, maybe for a moment, 22(d), or maybe talk about

 18 22(d).

 19 But why not let Barbara go to a financial advisor

 20 and say, "Well, I will pay you 50 basis points," or, "I will

 21 pay you 25, but take it out of my account." What's wrong

 22 with that?

 23 MR. RICHARD PHILLIPS: Well, I think there are four

 24 things wrong with it. Number one, it --

25 MR. DONOHUE: I mean, let the record show only Dick

 1 can speak in terms of four things.

 2 MR. RICHARD PHILLIPS: I want to say that the views

 3 I express are my own; they are not the views of my colleagues

 4 at Kirkpatrick; they are not the views, necessarily, of

 5 clients. Any resemblance between their views and mine is

 6 purely coincidental. They reserve every right to brand it as

 7 pure heresy.

 8 Having said that, I see four problems with

 9 internalization, and two problems -- four problems with

 10 internalization, or mutualization, as it is labeled here --

Page 204 
12b1transcript

 11 and two problems with externalization.

 12 The four problems are: it inhibits transparency,

 13 number one, compared to front-end load standard of

 14 transparency; number two, it increases the complexity of

 15 what, in concept, is a relatively simple concept of a mutual

 16 fund -- a collective investment vehicle -- it produces

 17 different classes, makes it difficult to compare performance

 18 and expenses; number three, it puts directors in a very

 19 uncomfortable role, they have to exercise responsibility over

 20 12b-1 fees that is really outside their control; and, number

 21 four, it inhibits competition, because the fund has to pay

 22 what the intermediaries charge -- and there is no effective

 23 shopping around, or negotiation, and no effective cost

 24 lowering, price competition. There is lots of competition on

 25 performance, there is competition on service, but not on

 1 price, with respect to that 75 basis-point sales charge.

 2 Those are four problems. Externalization would

 3 deal with those problems in a meaningful way. It would

 4 provide dollars and cents disclosure, hopefully at the point

 5 of sale and the confirmation, and in account statements over

 6 the period of time, shareholders would know what they're

 7 paying for. And if it's for service on a continuing basis

 8 and they aren't getting it, they may ask questions, and

 9 suddenly they may get it.

 10 Or, they can -- next time they buy mutual fund

 11 shares, they will try and shop around, and if they don't want

 12 service, they will try and get a lower sales charge. Very

 13 healthy. 

Page 205 
12b1transcript

 14 Secondly, directors would not have responsibility

 15 for determining whether a charge is reasonable. That doesn't

 16 mean they won't have responsibility over distribution. In

 17 particular, whether funds ought to be distributed in a

 18 particular channel, as well as what are the conflicts, what

 19 are the problems, what are the costs to the funds, to

 20 shareholders.

 21 But not for determining whether a fee is

 22 reasonable, and that's what makes them uncomfortable. And

 23 not to make a yearly determination whether it's in the best

 24 interest of shareholders to keep paying that fee, even though

 25 the fund may be closed.

 1 Number three, externalization would reduce

 2 complexity. Funds would not have to have all those different

 3 classes. May have to have more than one, but usually not

 4 more than two, if that much.

 5 And four, they could be shopping around.

 6 And five, in a sense most importantly of all, you

 7 would eliminate what I think is probably the most persistent

 8 and misguided criticism of the fund industry, which does a

 9 great deal of damage to the industry reputation. Even some

 10 very, very sophisticated observers do not seem to understand

 11 that 12b-1 fees are really a substitute, in large part, for

 12 the front-end load. They condemn it as a hidden subsidy. 

13 And that's simply misguided.

 14 It ain't true, the way 12b-1 is used today, and yet

 15 I am shocked at the sophistication of people who continue to

 16 repeat that mantra, particularly with respect to the payment 

Page 206 
12b1transcript

 17 of 12b-1 fees for closed funds, when they simply refuse to

 18 recognize that the 12b-1 fee paid today is for yesterday's

 19 sale, for the most part.

 20 MR. DONOHUE: Yes, I --

21 MR. RICHARD PHILLIPS: So, I think that the

 22 industry would be a lot better off with externalization. Are

 23 there problems? Yes, there is some cost. Whenever you have

 24 to make changes to your systems to accommodate each

 25 shareholder account, it's costly and it's complicated.

 1 On the other hand, is it more complicated than

 2 instituting a dividend reinvestment program, which has to be

 3 done periodically with very small amounts? I don't think so. 

4 And people I have talked to kind of laugh at arguments that

 5 it involves very substantial costs. The mutual fund

 6 industry, at least in the United States, is technologically

 7 very sophisticated, and it can handle it. Tax is a problem

 8 that it's not going to be able to handle.

 9 MR. NACHMANY: Yes, let me take -- you have a list,

 10 and I have a list. I have five things wrong with

 11 externalization.

 12 (Laughter.)

 13 MR. NACHMANY: The first one, it's going to drive

 14 the cost, the effective cost, to an investor, my guess,

 15 double what it is now. It's going to double the cost,

 16 especially for small investors.

 17 Why do I say that? Because when you look at other

 18 places where externalization is in place -- let's take

 19 separately managed accounts -- the average account is 

Page 207 
12b1transcript

 20 $300,000. The average fee on the very large accounts

 21 averaging with small accounts is, right now, about 1.7

 22 percent. But if you look at the low end of the market, it's

 23 somewhere from two to three percent. Our sophisticated

 24 investors, they have bargaining power. There is

 25 transparency, it's somewhere from 2 to 3 percent.

 1 So, as you think through these issues in

 2 externalization, the cost of advice in externalization, the

 3 economic equilibrium, has been set. It is significantly

 4 higher than the highest 12-month fees today --

5 MR. RICHARD PHILLIPS: Avi, implicit in your

 6 statement is that the mutual fund investor, for the 25

 7 basis-point service fee, gets precisely the same level of

 8 service as a separately managed account investment. I don't

 9 believe it, and I don't think you do.

 10 MS. ROPER: Plus, that separately managed account

 11 includes the investment advice and the fund management fee,

 12 and it includes --

13 MR. NACHMANY: It's about 30 or 40 basis points --

14 MS. ROPER: -- you know, personalization.

 15 MR. NACHMANY: -- or 3 percent. So it is not

 16 the --

17 MS. ROPER: So, I mean, it's not -- and it requires

 18 a certain volume, in order to be functional. So I don't

 19 think it is at all the same vehicle.

 20 MR. NACHMANY: Well, it is -- you know, I can argue

 21 the case -- so, anyway, there is a cost.

 22 Then this whole tax, we haven't talked a lot about 

Page 208 
12b1transcript

 23 the tax. You lose the tax issue. And if you look at the 10

 24 or 20 or 30 years time horizon, and you lose 20 basis points

 25 a year, this is a complicated issue, but the simplest

 1 way -- most people don't get it, but it's like buying a

 2 subway card out of your salary -- getting a salary reduction

 3 by a New York City subway card, versus paying cash. There is

 4 an advantage to paying before tax, and it adds up, it is

 5 significant over time.

 6 You also have the issue of transparency. For the

 7 life of me, I don't understand why, if Merrill Lynch has it

 8 externalized, and you try to compare how much you pay to

 9 Merrill Lynch, and how much you pay to Smith Barney, Don

 10 Phillips at Morningstar will not be able to show me those

 11 numbers on the web site. So I think it will actually reduce

 12 transparency, not increase transparency.

 13 And I think once you break the pricing rules, then

 14 brokers will say, "Why am I doing business with $10,000,

 15 $20,000 accounts? Why am I doing business? I have a limited

 16 amount of time. I will do business only with the high end."

 17 So, I think there is a problem with accessibility

 18 at the low end of the markets. The cost is going to be much

 19 higher, significantly higher, you lose the tax benefit, you

 20 lose transparency, and you lose accessibility with

 21 externalization. So I don't get it.

 22 MS. ROPER: I just want to say this model exists. 

23 I use it. I have a family financial planner, my payments are

 24 very transparent, and I implement through no-load mutual

 25 funds. 

Page 209 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

And I would argue that my costs are probably lower, 

when you combine my fees for advice and my fees for the 

operation of the fund, than they are in most or many 

brokerage accounts. And there is research that certainly 

supports this notion, that part of what you get, the benefit 

you get in paying 12b-1 fees, or loads purchasing through 

that channel, is higher cost funds, absent the distribution 

costs. 

And we were talking about this last night, and one 

person said, "But that's not a fair comparison, because they 

don't have access to those funds, those lower-cost funds." 

But that's the point. You have chosen to pay for advice in a 

way that denies you access to investments that may be in your 

best interest. 

I think there are two -- in the interest of arguing 

against myself -- the two biggest concerns I see about 

externalization, or say the one biggest concern I see about 

externalization, is this issue of what happens to small 

investors. And I think there is a very real issue about 

whether, as I say, costs come down for big investors but go 

up for small investors, or access for small investors is 

lost. 

I actually have a fair amount of faith in the 

industry's ability to figure out a new way to deliver to that 

market, if they view that market as worthwhile, so I don't --

Page 210 
12b1transcript

 1 MR. RICHARD PHILLIPS: I don't get that.

 2 MS. ROPER: -- necessarily think it is a lost

 3 cause.

 4 MR. RICHARD PHILLIPS: I don't get that. I am not

 5 suggesting -- unless transparency has some effect -- I am not

 6 suggesting that fees be lowered. I am suggesting that they

 7 be made more transparent.

 8 Do you think that the effects of transparency would

 9 be such that the brokers couldn't justify it? And,

 10 therefore, they would abandon the field? I never

 11 thought -- if so, then there is something wrong with the

 12 field.

 13 But if, in fact, transparency would have no effect,

 14 as Avi says, and others say, then there should be no

 15 impairment of the profitability to the broker-dealer, except

 16 for the cost of ink and paper for one more line on a

 17 confirmation account statement.

 18 MR. DON PHILLIPS: Dick, which fees are you talking

 19 about being externalized? I thought you had said, initially,

 20 that the 25 basis point you would leave internal --

21 MR. RICHARD PHILLIPS: I would leave it.

 22 MR. DON PHILLIPS: So, A shares, as they exist,

 23 would continue to exist.

 24 MR. RICHARD PHILLIPS: Would be unaffected.

 25 MR. DON PHILLIPS: An organization like Ariel,

 1 where Mellody talked --

2 MR. RICHARD PHILLIPS: Right.

 3 MR. DON PHILLIPS: -- about the importance of 

Page 211 
12b1transcript

 4 having -- that would continue to exist. So, really, what

 5 we're doing is debating C shares, since Avi has told us that

 6 B has gone away.

 7 MR. RICHARD PHILLIPS: That's right. So all we're

 8 talking about is C shares, which is really another way of

 9 charging a separate account fee, because you're talking about

 10 one percent over a period of time.

 11 Now, maybe you don't get the same services as a

 12 separate account, because you don't have the same amount of

 13 money, but that's to be expected. But I have difficulty

 14 understanding, unless transparency will really have

 15 devastating effects on brokers' compensation, I have

 16 difficulty understanding why costs will go up, except for the

 17 ink in adding a line to a confirmation, and an account

 18 statement. It's expensive, but not that expensive.

 19 MR. DON PHILLIPS: Yes, Avi's numbers on how B

 20 shares have fallen from favor are illuminating. A lot of

 21 discussion has come up today about how investors don't look

 22 at expenses, and I think that's true. They don't look at

 23 expenses. But there is an army of people out there who do

 24 look at expenses.

 25 And financial advisors, like Joe, who was on the

 1 last panel, they list expenses as the number one thing that

 2 they look at. So a lot of that is filtering through to

 3 investors, and influencing their decision-making. I have

 4 lost my train of thought.

 5 MS. ROPER: Well, in direct answer to Dick's

 6 point -- because on almost all of this I agree with 

Page 212 
12b1transcript

 7 him -- the reason I am concerned that investment costs could

 8 come down for large accounts and go up for small, is that

 9 when you charge on a percentage of assets basis, large

 10 accounts right now are subsidizing smaller accounts.

 11 They are paying the same percentage, but they're

 12 paying a lot more cash. And they also are those investors

 13 who will have the most ability to negotiate their fees with

 14 the broker, because they're attractive clients.

 15 I am not saying this is a reason it shouldn't be

 16 done. I am just saying it is the one thing that gives me

 17 pause about the issue of externalization.

 18 MR. RICHARD PHILLIPS: Yes, I have questions about

 19 the business judgement of that broker. If I were a broker,

 20 if I didn't see any other -- if I was losing money on a small

 21 account, I would get rid of it, and raise my profitability,

 22 except that I may want small accounts because the marginal

 23 cost is not that much.

 24 And number two, small accounts grow into big

 25 accounts, particularly if they have a good investment

 1 experience with me.

 2 MS. ROPER: Yes, watching investors' interest in

 3 small accounts is like the old watching hemlines go up and

 4 down. I mean, one decade we're about accumulating assets,

 5 and the next day we're about sending the small investors off

 6 to call centers.

 7 They make a business judgment. They have a right

 8 to make a business judgment about how much service that they

 9 want to give those accounts. But it's not always the same 

Page 213 
12b1transcript

 10 decision.

 11 MR. DON PHILLIPS: I see what we were talking about

 12 earlier, B and C shares, not a whole bunch of issues. You

 13 know, the retirement share classes, I think I am certainly in

 14 agreement that paying additional fees to service those

 15 accounts, and having that run through the fund, just seems

 16 like an appropriate usage of that. Paying for being on

 17 supermarkets seems like an appropriate usage of the fund.

 18 The real issue comes down to the B and the C

 19 shares. And I said earlier, investors don't look at

 20 expenses. But what they do see is the long-term impact that

 21 high fees have on expenses. And I would argue that that's

 22 the way, or the reason that the B shares have fallen from

 23 favor, is that they developed 10, 15-year records, and people

 24 saw the scarring of that record by the inflated expenses.

 25 And I think it's a very easy prediction to make,

 1 that the same thing will happen to C shares, once investors

 2 see the 10-year impact of paying a 1-percent load on C

 3 shares, especially if you get into areas like short-term bond

 4 and see just the debilitating impact that has.

 5 The question is how much damage do you want to have

 6 happen to investors, before you step in and look at that? 

7 But I would think, on the externalization or internalization

 8 the major thing is does it apply to all 12b-1 fees, or just

 9 this spread load factor, which I think, as Richard has

 10 pointed out, are very different debates.

 11 MR. DONOHUE: Don, if the investment performance

 12 was the reason why B shares were falling off, C shares would 

Page 214 
12b1transcript

 13 have fallen off sooner. Once you get beyond that period of

 14 conversion, the performance for C shares, long term, is worse

 15 than B shares.

 16 MR. DON PHILLIPS: But C shares, for the most part,

 17 don't have 10-year records yet.

 18 MR. DONOHUE: That's not --

19 MR. DON PHILLIPS: You know, most of them are

 20 newer, they have shorter histories.

 21 MR. DONOHUE: That is not --

22 MS. ROPER: There -- regulatory action --

23 MR. NACHMANY: Don, the C shares started in 1990 --

24 MS. ROPER: -- is what happened to B shares.

 25 MR. NACHMANY: They only have 17 years, and the

 1 big, big evolution of C shares in the marketplace was, like,

 2 in 1992 or 1993. So we have 14 years of tenure. I don't

 3 think that is --

4 MR. DONOHUE: Okay, we have 15 minutes left. What

 5 I would like to do, I would like to reach closure, have an

 6 answer, be able to package it, hand it to the Commissioners.

 7 (Laughter.)

 8 MR. DONOHUE: But that is not something that we are

 9 going to be able to achieve today. So what I would like to

 10 do is, first, I would like to invite Chairman Cox and the

 11 Commissioners to -- I know they're not shy, but if there are

 12 questions for this group, we've got them here, they can't

 13 leave for another 15 minutes. And then I would like to leave

 14 some time for closing statements by the panelists.

 15 CHAIRMAN COX: Well, Buddy, I don't see why we 

Page 215 
12b1transcript

 16 couldn't put a question somewhat like the one that you just

 17 put, possibly make it a little more susceptible of actually

 18 being answered by asking you to take two forks.

 19 Alternatively, first, imagine that all we are doing

 20 is leaving the status quo, but improving transparency. And

 21 then, second, imagine that you can do anything you like. 

22 What would be your favorite way to wrap this thing up?

 23 MS. ROPER: If what you want to do is improve

 24 transparency, then I think you have to figure out what you

 25 want to accomplish by that.

 1 And if the goal is particularly with regard to that

 2 portion of 12b-1 fees that goes to compensate brokers, to

 3 give investors the information they need to know what they're

 4 paying for and how much they're paying, then I think one of

 5 the approaches that you can take is account statement

 6 disclosure.

 7 If that's the goal, then that can be a post-sale

 8 disclosure, and you can -- the investor can then take that

 9 information, and decide whether they're getting services that

 10 are worthwhile, given what they're paying. And that could be

 11 a good thing to do.

 12 If what you want to do is arm investors to make

 13 better decisions, so that they can evaluate for themselves

 14 which share classes are appropriate for them, what's the best

 15 way for them to pay for the services they get from brokers,

 16 then I think that disclosure has to occur pre-sale. And, in

 17 fact, I think it has to occur at point of recommendation.

 18 And I think it has to be fairly simple and 

Page 216 
12b1transcript

 19 straightforward. It has to say, "This is what you're going

 20 to pay for the operation of the fund, this is what you're

 21 going to pay for the services of the brokers."

 22 I don't have a huge amount of confidence that that

 23 will change investor behavior. That doesn't mean it's not a

 24 worthwhile thing to do.

 25 If I could do anything, I would change the topic

 1 from 12b-1 fees to broker-dealer compensation issues, and

 2 have the Commission look holistically at these issues, to

 3 ensure that, one, it doesn't create incentives to simply move

 4 to a different form of non-transparent compensation within

 5 the mutual fund context, but more importantly perhaps, to

 6 ensure that it doesn't create a disadvantage for the sale of

 7 mutual funds, which I think we can all agree has been one of

 8 the great innovations for investors from recent decades.

 9 MR. FETTING: I would go down the path of

 10 modification of transparency, but also board oversight,

 11 pulling those things together, and talking about in

 12 comprehension the things that we have been talking about now.

 13 And I would like to leave with the thought of we at

 14 Legg Mason have had what people call C shares -- it's Primary

 15 Shares -- since inception of our funds and the Value Trust is

 16 our flagship fund. We have really strived to align the

 17 investment manager and the financial advisor together, to

 18 deliver this return realization for the client.

 19 It's not easy. It takes years of working together. 

20 It means kind of servicing counter-intuitively, not buying at

 21 the peak, but just the opposite. And that can happen. And 

Page 217 
12b1transcript

 22 so, I would like to point out that this so-called

 23 distribution fee can be viewed by the client as a service

 24 fee, and good value.

 25 And I would really urge that, when you look at

 1 this, the possibility that many of us inside Washington and

 2 related areas are informed, because we might choose

 3 personally to invest differently, but there are a lot of

 4 folks out there, so long as we respect them, are getting good

 5 value, and don't see this as the raging issue that some of us

 6 might.

 7 MR. DON PHILLIPS: Within the context of how things

 8 are today, I think the vast majority of what happens under

 9 12b-1 fees is something that is a legitimate investment cost. 

10 It is paying for additional services that you might get in a

 11 supermarket, it is paying for ongoing counsel from a

 12 financial advisor.

 13 And I think it is truly a benefit, to move from the

 14 incentive for the adviser being to sell something to generate

 15 a commission, or encourage a trade, to doing the hand-holding

 16 during tough times, when the markets get tough, and staying

 17 with the adviser. And that shift to an ongoing compensation

 18 is appropriate.

 19 And I do think that the vast majority of investors

 20 would prefer to have that fee be internalized. You know, if

 21 you were to break out the cost of Vanguard running their web

 22 site, and myself as a Vanguard shareholder would have my

 23 mutual fund, and some of the expenses would be in there, but

 24 then I would get a separate itemized bill on my account for 

Page 218 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript

 25 the ads that they ran in different magazines, or the cost of 

the web site, I would not see that as a step forward. 

So, with the way things are, I would say if you 

wanted to externalize fees, or you wanted to look at one 

thing differently, you would look at maybe the B and the C 

shares. And, as Avi pointed out, the B shares are maybe 2 

percent of the business, the C shares 10. It's really only 

the 12 percent of the industry that you're talking about, not 

the vast majority. 

Now, if I had my druthers, and could do whatever I 

want, what I would like to see is the industry stop reporting 

to shareholders their fees being management fees, 12b-1 fees, 

administrative fees, and other. 

Because, as I said earlier, those buckets really 

don't align. Some of what is going on in the 12b-1 fee is 

clearly an administrative fee. You know, some is a sales 

fee. In some cases, part of your distribution fee may be in 

the management fee from extra money that the fund management 

company is giving to different distribution or administrative 

platforms. 

And I would work to get mutual fund expenses into 

those three basic buckets, which would be: portfolio 

management cost; client service and advice; and 

administrative costs. And then, let the market debate what's 

the appropriate amount for each fund to have. 

And if I could make one final point on this, it was 

Page 219 
 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 23 

 24 

 25 

12b1transcript 

brought up earlier about the unified fee. I would argue 

strongly against that. I think it is important to have these 

broken down, in a sense. And the analogy I use is if you 

were looking at, say, a pharmaceutical company, and one was 

spending a whole lot on sales to sell the current lineup of 

drugs, and the other was spending a lot on R&D to develop the 

next generation of drugs, you would look at those two 

businesses as having very different prospects. 

And I think the same applies to a mutual fund 

company. You know, a lot of people are worried, is my fund 

manager not going to be competitive, or the top portfolio 

manager is going to be hired away to a hedge fund. Well, one 

thing to look at is how much of their cost goes to paying for 

investment professionals, and how much goes just to paying 

for access to be on different platforms. 

And I think the investor has the right to look at 

that. Maybe not every investor will, but I know that 

financial advisors would look at that. I know that 401(k) 

trustees would look at that, and they would like to see where 

their money is ultimately going, whether it's going to 

portfolio management, client service and advice, or 

administration. 

MR. RICHARD PHILLIPS: Even members of the same 

family sometimes have to part company. And on this point, I 

do disagree with my brother Phillips, in that I think, in

terms of effective communication, simple is better. And a 

Page 220 

 1 
12b1transcript

 2 unified fee is much simpler. And I think, for the great mass

 3 of investors, it will be better understood, and more

 4 susceptible for competitive comparison.

 5 That doesn't mean you don't make available to those

 6 investors, and certainly to the Morningstar analysts, the

 7 different buckets of expenses, and allow those who want to,

 8 to analyze further. But a uniform fee has a lot of merit to

 9 it, in terms of the ability of the average investor to

 10 appreciate, evaluate, and compare.

 11 Having said that, I also think that effective

 12 communication in the area of 12b-1 fees means dollars and

 13 cents communication. More is less. We have had enough words

 14 in prospectuses. You really need to tell investors, on an

 15 individual basis, how much their investment is costing them

 16 for sales charges.

 17 It probably is not feasible, as Barbara's

 18 suggestion, to make that disclosure in advance of the sale. 

19 I think you're going to find that it simply is not workable,

 20 and investors don't want to hear five minutes of verbal

 21 disclosure over the phone, when they want to get off the

 22 phone and back to their business, and on to doing what they

 23 want to do.

 24 But, over the longer term, if you had that

 25 disclosure in the confirmation in dollars and cents terms, if

 1 you had it in the account statements, over the longer term I

 2 think you would get a mutual fund investing public that is

 3 more sensitive to the issue of sales charge. And, over the

 4 long run, it would have a competitive effect by a more 

Page 221 
12b1transcript

 5 informed investing public.

 6 MR. NACHMANY: Yes, let me -- Dick and I have been

 7 doing this for a while. It has to be simpler.

 8 Now, I don't think any of us understand how we

 9 ought to do it so that Barbara's client, that our client, is

 10 actually going to get it. Just to do something new, add

 11 something new, that will not influence anyone's decision is

 12 not the solution. We need to make it clearer, but make sure

 13 we understand how to do that, that it gets to people.

 14 So, that is on the disclosure and clarity of

 15 -- maybe we should call it, instead of 12b, call it b12,

 16 people can see it as something that will help them.

 17 But I think externalization is a terrible idea. 

18 Over life -- that's my judgment -- over lifetime of

 19 investment, it will cost a person, relative to mutualization,

 20 20 or 30 percent of their investment, in many cases,

 21 especially at the lower end. If it's not 20, it's 15. It's

 22 a terrible idea.

 23 And to me, closing out, it's one of those things, a

 24 couple of days ago, it's Father's Day, and I am working on a

 25 paper, 12b-1 fees, and my kids are trying to understand

 1 what's behind my effort. So I was reflecting on some of

 2 these issues.

 3 You know, I grew up on a chicken farm, and one of

 4 the things you learn is when you drop an egg, you can't fix

 5 it. You can't put it together. This is sort of -- 12b-1 is

 6 one of the elements of the house that we have built. It's

 7 part of the cement. And let's not break it and see, "Well, 

Page 222 
12b1transcript

 8 maybe it's going to work this way, maybe it's going to work

 9 that way." We don't know how it's going to work.

 10 Clearly, it is working. Fine-tuning, clarity,

 11 better understanding is needed, but let's not drop the egg

 12 and hope for the best.

 13 MR. DONOHUE: I have never thought of 12b-1 as a

 14 chicken egg. But I think that's probably a good point for us

 15 to end.

 16 And I want to thank the panelists. You put a lot

 17 of effort into this, and provided a lot of help to all of us. 

18 I want to thank everyone in the audience for sticking with us

 19 through a rather long day, and particularly those on webcast.

 20 And I don't know if the Chairman has any closing

 21 remarks, but --

22 CHAIRMAN COX: Well, I thank you, Buddy, for doing

 23 an excellent job, and also the moderators that preceded

 24 you -- Erik and Doug -- and to all of our panelists,

 25 particularly this last panel. You did an excellent job in

 1 setting the table for us closing.

 2 We have got, as the Commission, a lot of work ahead

 3 of us. We hope we can continue to have the benefit of your

 4 advice. But thank you very much for all of the work and the

 5 preparation that you did to get us to this point.

 6 And with that, Buddy, I think we can call it a day. 

7 Thanks to everyone.

 8 MR. DONOHUE: Thank you.

 9 (Applause.)

 10 (Whereupon, at 5:13, the conference was adjourned.) 

Page 223 
12b1transcript

 11

 12

 13

 14

 15

 16

 17

 18

 19

 20

 21

 22

 23

 24

 25

Page 224