SEC Proposes Revisions to Mutual Fund Distribution Fees (Rule 12b-1) and Disclosure

On July 21, the Securities and Exchange Commission (SEC) proposed new rules and disclosure requirements that, if adopted, will significantly change the existing framework governing the use of mutual fund assets to pay for distribution (the Proposal).1 The Proposal has widespread implications not only for mutual funds and their boards of directors and investment advisers, but also for broker-dealers and other financial intermediaries that sell fund shares or service fund shareholder accounts.

Background

Adopted in 1980, Rule 12b-1 under the Investment Company Act of 1940 (Investment Company Act) permits a mutual fund to use fund assets to pay broker-dealers and others for providing services that are primarily intended to result in the sale of the fund's shares. In the years since the rule's adoption, the mutual fund industry has seen tremendous growth and experienced significant changes in the way that mutual funds are offered and sold. In the Proposal, for example, the SEC notes the transition from mutual funds being primarily sold by brokers to being distributed significantly through fund supermarkets and other types of intermediary arrangements. The SEC also notes the emergence of multiclass arrangements that accommodate selling through multiple distribution channels. Relying on data from the Investment Company Institute, the SEC observes that in 2009 mutual funds paid $9.5 billion in Rule 12b-1 fees and that more than half of Rule 12b-1 fees were paid to broker-dealers and other financial intermediaries for providing services to investors after the sale of fund shares.

Based on the belief that the distribution framework established under Rule 12b-1 no longer reflects the economic realities of modern-day mutual fund distribution, the SEC's Proposal would rescind Rule 12b-1 and replace it with a new framework that would separately regulate what the SEC identifies as the two primary component parts of Rule 12b-1 fees: services fees and asset-based sales charges. Service fees, which would be capped at a relatively low amount and would compensate intermediaries for sales and services, would be permitted under new Rule 12b-2. Asset-based sales charges, which also would be capped but at significantly higher amounts, would be governed by amendments to Rule 6c-10. In addition, for the first time, the Proposal would permit brokerdealers (rather than the individual funds) to establish their own sales charges on the sale of fund, which the SEC believes will foster retail price competition among dealers in mutual fund shares. The Proposal also impacts the role of a mutual fund's board of directors in overseeing the distribution of the fund's shares. While the adoption by individual boards of distribution plans based on specific determinations and findings as required under existing Rule 12b-1 would be eliminated, the Proposal is clear that directors will continue to have fiduciary obligations under state law and Section 36(a) of the Investment Company Act to oversee the use of fund assets to pay for distribution.

Elements of the Proposal

Marketing and Service Fee—Proposed Rule 12b-2.

If adopted, the Proposal would rescind Rule 12b-1 and replace it with Rule 12b-2, which would permit funds to deduct a "marketing and service fee" from fund assets to pay for "distribution activities." The definition of "distribution activities" would carry over unchanged from the current definition under Rule 12b-1(a)(2).2 A Rule 12b-2 marketing and service fee would be capped at the service fee limit established under FINRA (NASD) Rule 2830 (currently 25 basis points (0.25%) annually). A fund may use marketing and service fees for the following purposes:

Payments for personal service and/or the maintenance of shareholder accounts Trail commissions to broker-dealers selling fund shares Fees paid to fund supermarkets, which can be distribution related Payments to retirement plan administrators for services provided to plan participants (and which relieve the fund from providing such services) Traditional distribution activities, such as shareholder call centers, compensation of underwriters, advertising, and printing and mailing of prospectuses to other than current (i.e., prospective) shareholders The Proposal would require a fund to obtain shareholder approval of the adoption of, or any increase in, a marketing and service fee after the public offering of the fund or the particular share class. With respect to fundof- funds arrangements, Rule 12b-2 would permit both an acquiring fund and an acquired fund to charge a marketing and service fee, so long as the total of the fees charged by the funds together does not exceed the FINRA (NASD) service fee limit (25 basis points).

Although the Proposal would eliminate the requirement that fund boards adopt a distribution plan and make specific findings and determinations with respect to such plan, the Proposal makes clear that fund boards will continue to have fiduciary obligations under state law and Section 36(a) of the Investment Company Act to oversee the use of fund assets to pay the marketing and service fee. In this regard, fund boards would be required to approve the adoption of the marketing and service fee under the Proposal, and it is the SEC's intention that fund boards would oversee the amount and uses of the marketing and service fee in the same manner that it oversees the use of fund assets to pay other fund operating expenses, particularly any instances that create a potential conflict of interest with a fund's investment adviser or other affiliated persons. The SEC release did not contain any specific guidance as to what factors should be considered by fund boards when determining whether the level of the marketing and service fee is (or is not) appropriate for a particular fund.

Ongoing Sales Charges—Amendments to Rule 6c-10. The Proposal would amend Rule 6c-10 under the Investment Company Act to permit funds to charge asset-based distribution fees in excess of the marketing and service fee permitted under Rule 12b-2. Such excess amount would be called an "ongoing sales charge," subject to aggregate limits imposed under Rule 6c-10.3 As long as the rate is consistent with the cumulative maximum sales charge limit, funds will be free to determine the rate of the ongoing sales charge.4 The cumulative sales charge limit would apply separately to each share...