About That First Eagle Case

This article has been corrected since its publication.

Edit: In hindsight, this column expresses too much certainty about the level of First Eagle’s culpability. The settlement order permits a variety of interpretations, including simple negligence. (The views expressed in the article are merely my views and should have been preseted as such.)

The facts outlined in the column remain, as do the general points about the potential conflict between shareholders of funds and of fund companies and the small size of First Eagle’s infraction. Across the industry, legal 12b-1 costs surely dwarf the illegal costs that the SEC seeks to uncover with its Distribution in Guise initiative.

Money, Money, Money As you may have seen, the SEC brought action against First Eagle Investment Management last year for improperly spending shareholder assets. Through its 12b-1 plan, First Eagle is authorized to spend about $200 million per year of shareholder monies on distribution and marketing. Finding that amount to be insufficient, First Eagle dipped into the funds further. It funneled assets that were billed as paying for "transfer agent" services to financial advisors as compensation for selling fund shares. Transfer agents don't sell new shares; instead, they perform mundane operational tasks, such as officially registering fund shares.

The company's misdeed lay not in purchasing additional distribution beyond what its 12b-1 fees financed, which is perfectly legal. The violations instead were of misappropriation and mislabeling. Once First Eagle had exhausted its 12b-1 expenditures, it was required to spend its own money for further distribution and marketing activities, not those of its investors. Then, because it was wrong to spend fund assets for those functions, the company covered up its actions by mislabeling an expense account. In essence, it took from the cookie jar while pretending that it did not.

(The malfeasance affected neither the funds' total returns nor their expense ratios. Fund returns automatically reflect all asset outflows, because NAVs are calculated from the assets that exist in a fund at the end of each trading day. And although there are some frauds that could affect stated expense ratios, this was not one of them. The affected assets had been properly encoded as fund expenses--just not the correct flavor of expenses.

Edit: The above paragraph was correct in a narrow sense, but not helpful. My meaning was that if the distribution expense had been listed correctly as a distribution cost instead of incorrectly as a sub-TA cost, and that the distribution expense had continued to have been paid by the fund, that neither the fund's total returns nor its expense ratio would have changed. My comment was made while thinking about the accounting implications of switching an expense's cost bucket.

But, of course, the whole point of the SEC's action is that the distribution expense would not have been by paid by the fund if it had been correctly identified. In which case, yes, the expense ratio would have declined and the total returns would have increased.

I closely watched the leaf--and missed the tree.)

Three take-aways:

1) The Bogle Principle One of Jack Bogle's favorite themes is the conflict between fund shareholders and fund-company shareholders. Fund shareholders would like the fund company to keep its hands off portfolio assets, while fund-company shareholders, quite understandably, have the opposite desire. Setting aside the bogus argument that higher fund expenses benefit current shareholders because those monies are used to attract new investors, and then the fund becomes cheaper due to an economy of scale, an argument that has been proved to be false, the game is zero-sum. Money for one party comes from the pockets of the other.

The principle was amply demonstrated by First Eagle. The company could easily have financed its distribution costs by using its own assets. First Eagle, like any fund company of size, is highly profitable, with revenues (and profits) that are far, far higher than the payments in question. But First Eagle's management wished otherwise. It thought more highly of the needs of its own shareholders than it did of the funds' owners.

2) The Violation Was Senseless First Eagle did not just think small, it thought tiny. The unauthorized payments amounted to a mere $25 million, spread over six years. During that same time period, the company collected more than $2 billion in official management fees. While First Eagle's executives had good reason to believe that they would not be caught, because the SEC until then had not filed such a case, the payoff for the ruse was nonetheless puny relative to the great existing revenues.

First Eagle's management became greedy. In this instance, Mr. Gekko was wrong: Greed was not good. Setting morality aside, and evaluating First Eagle's decision solely from the perspective of maximizing its shareholders' wealth, the accounting trick was dumb. The company's executives made an error of emotion.

3) 12b-1 Fees Are Huge! First Eagle, a successful but by no means giant fund company, collects $200 million of 12b-1 fees each year. For the industry overall, the figure is from $12 billion to $15 billion. (I could get a precise figure after crunching a lot more numbers, but that is close enough for this article's purposes.) For perspective, annual U.S. box-office receipts for domestic film sales are $10 billion, and NBA revenues are $7 billion. That is a very large amount indeed for an expense item that few people even know exist, and that fewer still can even vaguely describe.

Yet, for First Eagle, that was not enough. The business of selling mutual funds is a big business indeed.

What's Next? Ominously for fund companies, the SEC suggests that the First Eagle settlement is but the beginning. It states:

The case is the first arising out of a recent SEC initiative to protect mutual fund shareholders from bearing the costs when firms improperly use fund assets to pay for distribution-related services. Known as the Distribution-in-Guise Initiative, the SEC is seeking to determine whether some mutual fund advisers are improperly using fund assets to pay for distribution by masking the payments as sub-transfer agency (sub-TA payments).

(Note to the agency: You have a modifier that needs fixing.)

This supports what I had previously heard from William Birdthistle, a law professor who specializes in mutual fund legislation. (I'll discuss his forthcoming book on the mutual fund industry, published by Oxford University Press, when it is released.) In William's view, the SEC has been lax at enforcing fund-industry regulations, in part because of a lack of funding, in part because of a lack of Congressional support, and in part because of the common tendency of regulators to be "captured" by the industry that they track. Now, he thinks, the SEC may be on the hunt. (Although, he adds, one case does not a campaign make.)

Better Yet I don't see how that can be anything but good for fund investors. On the other hand, as demonstrated by this case, the stakes are small. The biggest problem for fund shareholders is not what is done outside the law, but rather within it. The 12b-1 fee should not have been invented, nor should it continue to exist. Its abolition would immediately and dramatically lower fund expense ratios.

Yes, many of these costs would be moved elsewhere, as distributors impose new charges to compensate for their loss of 12b-1 dollars. But unlike with a 12b-1 fee, which is charged to every shareholder regardless of whether the shareholder uses the services purchased by the 12b-1 fee (such as a no-transaction fee platform), these new charges would be unbundled. They would only be levied upon those who chose them. You can't ask for fairer than that.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.