VI. the Acid Test: Does Rule 12b-1 Benefit Mutual Fund Shareholders?

That the SEC's staff filibustered for years against Rule 12b-1 attests to deeply ingrained skepticism among highly knowledgeable group of fund industry experts about the basic precept that fund sales financially benefit existing shareholders. The Commission and its staff greeted with skepticism the industry's purported justifications for allowing assets to be diverted to spur sales. (143) By deferring to fund directors' business judgment, the SEC elected to give fund industry leaders an opportunity to prove their theories worked. The SEC's business judgment experiment has now been running for more than 26 years. A. The Economies of Scale Argument Is Unsubstantiated A recurring claim made by the industry prior to Rule 12b-1's adoption was that by generating sales and thereby growing funds' assets, administrative and management costs would fall, allowing fund to, in essence, realize net gain on their invested marketing dollars. (144) The idea was that money could be taken from mutual fund by the fund's adviser or distributor to pay for 12b-1 marketing efforts, with the diverted funds being put to work in way that would yield savings through economies of scale realized as the fund grew in size. This theory has not panned out. The SEC's staff found in its December 2000 report on fund expenses that, everything else equal, funds with 12b-1 fees had total expenses that were higher than those of other funds, but by an amount that was slightly less than the maximum 12b-1 fee. (145) In other words, the SEC found that funds spending more 12b-1 money saw their expense ratios rise by approximately the amount of money diverted. This is far distance from validating the contention that 12b-1 payments would in essence pay for themselves. More recently, an SEC-employed economist, Dr. Lori Walsh, conducted private research that carefully reviewed data concerning 12b-1 fees, and concluded: While funds with 12b-1 plans do, in fact, grow faster than funds without them, are not obtaining benefits in the form of lower average expenses or lower flow volatility. Fund are paying the costs to grow the fund, while the fund adviser is the primary beneficiary of the fund's (146) Dr. Walsh did not mince words, finding that shareholders do not obtain any of the benefits from the asset growth. (147) This finding vindicates opponents of using fund assets to subsidize sales who warned about funds being exploited by their funds' conflicted managers. (148) The findings made by the SEC staff and Dr. Walsh accord with other similar studies; the evidence is overwhelming that 12b-1 payments do not generate net financial benefits for fund shareholders. (149) Another serious problem with the growth begets savings scenario is that asset growth in the fund industry does not guarantee costs will drop at all. A Government Accounting Office report published in 2003 found that sample of 46 large stock mutual funds which, together, had growing asset base, (150) also had experienced rising average expense ratios, with costs growing from 0.65% of assets in 1998 to 0.70% in 2001. Meanwhile, the average mutual fund shareholder, until very recently, has tended to find expenses creeping higher. (151) Decade after decade of rising costs casts doubt on the concept that asset growth can be counted on to generate economies of scale for shareholders, however the asset growth may be financed. Moreover, scholarly research has identified a negative persistence in fund performance [for large funds] supporting the hypothesis that funds can become large and inefficient. (152) Indeed large equity funds sometimes close to new investors if the fund becomes too large to effectively deploy capital. (153) The fact that fund asset growth financed by 12b-1 fees fails to yield tangible benefits for fund has serious legal ramification. …