Understanding the Financial Stress of B Shares in a Bear Market Print E-mail
Written by Robert T. Fleisher, a mutual fund financial consultant and C. Meyrick Payne   

There are more than $300 billion in open-end mutual fund assets with deferred-load share classes. This figure translates into more than $12 billion of commission advances that have been provided by fund distributors in anticipation of recouping this outlay through the collection of 12b-1 fees and contingent deferred sales charges over a period that is typically eight years in duration. Outside credit providers or the distributor's shareholders have either implicitly or explicitly financed this entire amount.

Given the surge in popularity of deferred-load shares (commonly referred to as B-shares) during the second half of the previous decade and the extended downturn in the global equity markets, trustees for mutual funds that issue such share classes need to understand the economics of "B" shares and the subtleties that affect the recovery of commissions advanced.

 

How B Shares Work?

The justification for establishing multiple share classes for an individual mutual fund is to grow the assets under management within the fund to allow shareholders to benefit from economies of scale (e.g. advisory fee breakpoints, regulatory fees, etc.). Unlike front-end load shares where the selling agent's commission is directly deducted from funds invested by the shareholder, the B-share fund distributor advances funds to the selling agent (typically 4% of the amount invested) prior to receiving anything.

The sole related asset of the distributor is the obligation contained in provisions of the distribution agreement under which the fund agrees to pay the distributor an asset-based fee (typically between 0.25% and 0.75% per annum) over the life of the share. In addition, to protect the fund distributor from the risk of shares being redeemed before the fund distributor has had an adequate chance to recoup its outlay, the shareholder agrees to pay the distributor a contingent deferred sales charge that decreases to zero over time.

Given the increase of volatility in the equity markets over the same period of time that B-shares became so popular, the type of fund that was sold by the distributor has a direct impact on the likelihood of the distributor being able to recoup their outlays (including amounts to cover the cost of the capital to make such advances). During the first three quarters of 2001, Comerica Inc. has taken $40 million of charges to its income statement in order to reflect the impairment to the asset on its balance sheet which represents the market value of the amount it expects to receive from 12b-1 fees and contingent deferred sales charges related to advances made to brokers to sell B-shares from funds advised by its Munder Capital Management unit.

December 2001 Management Practice Inc. periodically issues Bulletins about important topical issues concerning mutual fund governance. A full anthology is available at www.mfgovern.com.

While the timing of Munder's sales and the composition of its funds present an extreme example relative to the issues related to B-share outlays by the rest of the industry, trustees should understand the risks undertaken by their own fund distributors and the effect that actions taken by the advisor and the board can have on the ability of the distributor to receive fair compensation for providing this valuable service.

The Source of Financial Stress

While the investment performance of a fund's shares are the primary driver in dictating the return to the distributor on their capital outlay, subtle actions can have an effect on cash flows as well. In order to illustrate the subtleties that can affect these cash flows, here are two relatively low profile examples of activities and policies that can potentially decrease the cash flows recouped by the funds distributor

Changes in portfolio management: A new portfolio manager can come in and completely reposition the fund's portfolio. This can have the effect of creating a large capital gain distribution, which regardless of the reinvestment rate can lower the amount of redemption protection for the distributor. Contingent deferred sales charges are typically based on the lower of cost or market value and are not charged on reinvested shares.
Lack of an active retention program: Advisory fees are tied to the level of assets in a given fund and are largely unaffected by the level of redemption activity in a fund as long as new sales are being generated to replace the assets that have left the fund. A fund complex that is overly focused on net sales and not focused enough on minimizing redemptions can create a hidden strain on the fund distributor that will not be evident for several years.
During the great bull market of the 1990s, the Boards of some mutual fund complexes put procedures in place to limit the recovery of commission advances through the acceleration of the conversion of "B" shares to "A" prior to their normal time frame. With the benefit of hindsight, this action may have inadvertently undervalued the service provided by the fund distributor that assumed the risk of helping the fund to grow by advancing commissions.

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As a companion to understanding the legalities involved, the trustees of a fund should understand both the economics of the risk borne by fund distributors. From the drafting of distribution agreements to the effect of fund mergers, subtle issues and events affect the huge collective financial burden of pre-funded "B" shares. In an era of increased volatility, little things can mean a lot.