Are 12b-1 Fees Paid to Registered Representatives in Violation of Investment Advisers Act of 1940?

June 26, 2007

As the United States Securities and Exchange Commission (SEC) has started to scrutinize the current practices related to 12b-1 fees, several securities industry commentators have noted that the payment of 12b-1 fees by mutual funds to broker-dealers is likely in violation of the Investment Advisers Act of 1940 for those registered representatives that utilize the 12b-1 fees as a method for paying such registered representatives for their monitoring and ongoing advice to clients regarding their investments.

Under the Investment Advisers Act, an investment adviser is defined as an entity or individual that provide advice about securities for compensation in any form and engages in the regular business of providing advice about securities. However, Section 202(a)(11)(c) of the Investment Advisers Act excludes from the definition of an investment adviser “…any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor….” It’s on this basis that broker-dealers and their registered representatives avoid the numerous requirements of the Investment Advisers Act.

As noted by these securities commentators, many of the activities performed by registered representatives are purely investment advisory services that are not transactional related. In other words, the monitoring and providing of ongoing investment advice in exchange for a 12b-1 trail fee is not solely incidental to the business of a broker, which is the execution of securities transactions. Moreover, it was noted that these 12b-1 fees strongly resemble the recently struck down fee-based brokerage accounts. It’s difficult for an objective bystander to review the justifications for the 12b-1 fee by its proponents and not conclude that there’s a violation of the federal laws regulating investment advisers.

The time has come to level the playing field between broker-dealers and investment advisers. If a registered representative of a broker-dealer is providing ongoing advice about mutual funds for a quarterly, asset-based trail, then the SEC needs to start requiring such registered representative and his or her broker-dealer to meet the higher fiduciary obligations of a registered investment adviser.

Posted by Bryan Hill
Labels: SEC