Independent directors of mutual funds have come under scrutiny for allowing fees on funds to go ever higher. But another practice that has been receiving much less attention raises the same question of whether these directors are, indeed, fulfilling their mandate to act in the interests of the shareholders.
At issue is a relatively new high-finance niche in which banks advance loans to mutual fund companies against sales charges and fees they expect to collect from shareholders years in the future.
The catch is that the marketing fees involved, called 12b-1 fees, are not automatic but must be approved each year by a fund's independent directors -- those appointed from outside the company -- as being in the shareholders' interest.
So a fund company that takes out a loan against these fees, before they are even approved, is banking on the continued willingness of the independent directors to grant them. In many cases, the loans are secured by nothing more than this expected stream of income.
This type of loan has become more common as mutual fund investors buy classes of shares that carry continuing fees or deferred sales charges, instead of shares with an initial fee, or load, that takes a big bite of the investing principal.
For many fund companies, however, this creates a problem because the brokers who sell the shares want their commissions right away.
To span the gap, banks including Chase Manhattan, Citibank, PNC Bank and the Bank of Boston have been increasingly offering these bridge loans to fund companies over the last two years.
In banking circles, the practice is known as "B-share financing," because B shares are a class that typically carries a back-end load, or sales charge that declines and is usually eliminated as a shareholder owns the fund for longer times.
B shares also typically charge 12b-1 fees to cover sales and distribution expenses, but they cannot be assessed just any time a fund company pleases. To guard against abuse of 12b-1 fees by boards that may be too cozy with the fund advisers and distributors who collect them, the Securities and Exchange Commission requires that the fees can be levied only if they benefit existing shareholders -- for example, by increasing the number of shareholders among whom overall fund expenses can be spread.
The SEC also says the fees must be re-approved each year by the independent board members.
Given these limits, critics ask: How can fund distributors and advisers -- who take out loans spanning several years against 12b-1 fees -- assume that independent directors will continue to find that those fees are in the interest of shareholders?
"It makes you wonder about how they regard the so-called independence of the independent directors," J. Boyd Page, a shareholder-rights lawyer with Page & Bacek in Atlanta, said of fund advisers. "They are making the assumption that those fees are going to be approved, when that is not a valid assumption. Things can change a lot over the course of the loan."
The fund, for example, may become so big that further expansion will not do much to spread out the other management fees. Or it may simply grow so big that its management believes the fund would be better run if it closed to new investors.
"I am not at all shocked by this," said Michael Mulvihill, who studies mutual fund expenses for Morningstar Inc., the fund researchers in Chicago. "It is understandable that lenders will assume the 12b-1 fees will be approved year after year because, historically, the independent directors, who are responsible for keeping an eye on the fees, have not done a very good job of that when the fees are beneficial to the management company."
Fund companies and the SEC, however, are quick to defend these loans.
"The directors have an obligation under 12b-1 to look at these fees every year and decide if they are in the benefit of shareholders," said Bob Graham, chief operating officer and president of AIM Management Group, fund operators in Houston. "Whether we borrow money or not, there is no pressure on the board to vote either way."
Jack W. Murphy, the chief counsel for the SEC's division of investment management, said: "We know about this practice, and we don't see that there is a danger for fund shareholders here. The distributor cannot independently create an obligation on the part of the fund to pay 12b-1 fees. The board makes that decision on an annual basis. If it is not in the best interest of the fund and the shareholders to continue the 12b-1 plan, the board has an obligation to shut it down. It does not matter what the distributor told the bank when it took out the loan."
Defenders of continuous 12b-1 fees argue that they help funds in various ways. Kurt Cerulli of Cerulli Associates, a consulting firm to mutual funds, stressed the fees' value in helping to keep a fund's asset base from shrinking, and thereby keeping overall fees down.
And by supporting the brokerage network that shareholders turn to for guidance, the 12b-1 fees can help funds whose marketing strategy is to aim for clients who want to pay for advice.
Critics, however, do not see how 12b-1 fees, which are collected daily as a deduction from a fund's net asset value, do much for shareholders.
"In practice, the main impact of the 12b-1 fee is to help the adviser, even though it was originally sold as an idea to be beneficial to shareholders," Mulvihill of Morningstar said.
Part of the reason the fees are approved year after year, even if they do not clearly help shareholders, is that directors may be too close to fund company management, Mulvihill said.
A Morningstar study last summer, for example, found a correlation between the fund companies' compensation of independent directors and the expenses that the directors then allow the fund to charge investors -- in other words, the better the trustees' pay, the higher, instead of lower, the fees.
What's more, Mulvihill said, mutual fund expense ratios rarely decline when funds become bigger, even though economies of scale -- and the 12b-1 argument -- suggest that when funds grow, the fees as a percentage of assets should decrease.
Pub Date: 12/29/96