Business Day

S.E.C. Turns Its Eye to Hidden Fees in Mutual Funds

SEPT. 25, 2015

As regulators have ramped up their scrutiny of private equity practices in recent years, investors have learned a lot about hidden — and dubious — fees they are paying.

Now it’s time for investors in the $16 trillion mutual fund arena to do the same.

On Sept. 21, the Securities and Exchange Commission’s enforcement division filed proceedings against First Eagle Investment Management, an asset-management company overseeing $100 billion — mostly in eight stock, bond and multi-asset funds. The S.E.C. said that from January 2008 through March 2014, First Eagle improperly billed its investors $25 million for payments to brokers marketing the funds’ shares. The commission also accused First Eagle of misleading investors by maintaining in fund documents during that period that it was paying the marketing costs itself.

First Eagle settled the matter without confirming or denying the allegations. It agreed to pay about $27 million in disgorgement and interest as well as penalties of $12.5 million. The S.E.C. will set up a fund to return money to investors who were harmed by First Eagle’s actions.

As a modest First Eagle fund shareholder, I am one of them.

Under S.E.C. rules, fund companies like First Eagle can charge shareholders for some costs associated with attracting new money and investors. Such fees fall under a so-called 12b-1 plan, named for the S.E.C. rule governing its use.

That plan is subject to approval by a fund company’s board; funds seeking to pay marketing costs above those set out by the 12b-1 plan must take them out of their own pockets, not those of their investors.

First Eagle broke that rule. In a statement, the fund company said it regretted the matter and had improved its procedures. “The S.E.C. has acknowledged First Eagle’s cooperation,” the company added, “noting that we acted promptly to remedy the issue and that we immediately offered to return the money paid from the funds’ assets.” (My share will be nominal.)

A First Eagle spokesman declined to comment further.

“Of course, the problem is much bigger than this one case,” said Barbara Roper, director of investor protection at the Consumer Federation of America. “The S.E.C. has allowed 12b-1 fees to morph into distribution fees when they were originally intended to serve a very different purpose. The agency had a reform proposal ready to go back in the early days of this administration, but the industry didn’t like it, so it never went anywhere.”

There are signs, however, that the First Eagle case may be just the initial S.E.C. salvo on improper mutual fund fee practices. Tricks involving 12b-1 fees are a rich vein for the S.E.C. to mine because these charges are exceedingly opaque. Bringing cases in this area is crucial for investors since these fees drag down fund returns.

These fees also pose real conflicts of interest. Investment advisers are paid based on a percentage of assets under management; as these assets grow, so does the adviser’s income. Marketing a fund helps increase assets under management, so the investment adviser is the primary beneficiary of any fees paid for that purpose.

“Mutual fund advisers have a fiduciary duty to manage the conflict of interest associated with fund distribution, namely whether to use their own assets or to recommend to their fund’s board to use the fund’s assets to distribute shares,” Julie M. Riewe, co-chief of the asset management unit in the S.E.C.’s enforcement division, said in a statement. First Eagle breached that duty, she added.

The mutual fund industry says such fees help investors who are seeking advice about what offerings to buy by paying brokers to make those recommendations.

The S.E.C. adopted the 12b-1 rule back in 1980, when many funds were experiencing large redemptions. Allowing fund investors to pay some marketing costs was supposed to help counter the outflows. At the time, 12b-1 fees amounted to a few million dollars per year.

But those days are long gone, and in 2010 — when the S.E.C. proposed a new rule limiting the amount a fund could charge its investors in 12b-1 fees — these fees had jumped to $9.5 billion annually. At the end of last year, the fees stood at $12.4 billion.

First Eagle started down its problematic path on marketing fees in 2008, the S.E.C. said. That may not be a coincidence. The markets were being roiled by the mortgage crisis, and First Eagle investors were fleeing. The fund company recorded $675 million in net outflows that year, according to Morningstar, the mutual fund researcher.

During the roughly six years that the S.E.C. said First Eagle was shifting marketing costs to investors, the company’s funds netted $23.1 billion in new investor money, Morningstar data shows. Assuming that investors paid First Eagle’s typical 0.75 percent management fee, it generated roughly $173 million on that fresh cash.

It is impossible to know how much of this cash came in because of the improper use of investor money, but it’s clear that First Eagle could have paid the $25 million in marketing costs itself. Fund documents show that in the 2014 fiscal year alone, the funds’ investment adviser received $558 million in management fees. For a relatively small company like First Eagle — it has 166 employees — that’s a big chunk of change.

First Eagle’s costs will increase as a result of the S.E.C. deal. It must hire an independent consultant to review its use of fund assets for activities aimed at increasing the sale of fund shares.

Two private equity firms — Blackstone Management Partners and Corsair Capital — are proposing to buy a majority stake in First Eagle. The deal, which will keep First Eagle independent, is expected to close later this year.

First Eagle’s website contains a list of its guiding principles. This is one of them: “Always act with honesty, integrity and transparency. Never have anything to hide.”

A version of this article appears in print on September 27, 2015, on page BU1 of the New York edition with the headline: Dubious Marketing Fees Catch the Eye of the S.E.C.

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