On July 21, 2010, the Securities and Exchange Commission voted unanimously to propose new rules to replace the existing rules governing mutual fund distribution and marketing fees, including fees commonly known as 12b-1 fees. The new rules are also intended to improve the disclosure of these fees to investors.
Background.Adopted in 1980, Rule 12b-1 under the Investment Company Act of 1940 allows mutual funds to charge fees (generally referred to as 12b-1 fees) that are deducted from the assets of the fund in order to pay for marketing and distribution expenses. These expenses often include payments for general marketing and advertising efforts, compensation of securities professionals who market and sell fund shares, and shareholder servicing expenses such as recordkeeping and costs related to the preparation and mailing of shareholder reports. 12b-1 fees have also been widely used as an alternative to up-front sales charges, or “loads.” Although amounting to only a few million dollars industrywide in 1980, these fees amounted to approximately $9.5 billion in 2009.
12b-1 fees have been criticized for the alleged lack of transparency associated with their amount and use. Critics have also questioned the appropriateness of continuing to charge investors 12b-1 fees long after they have purchased their shares. On the other hand, others have noted that these fees support expenditures that are necessary in today’s competitive marketplace and that they offer investors useful alternatives to up-front sales loads. They also point out that these fees help ensure that fund intermediaries provide continuing non-distribution-related services to shareholders who may have need of assistance long after they initially purchased shares. Citing the need to modernize and improve the rules governing these fees, SEC Chair Mary Schapiro explained that the proposed rules are intended to “provide clarity and fairness to a mutual fund distribution system that has become confusing and potentially anticompetitive.”
The proposed rules would replace current Rule 12b-1 and address four primary objectives: capping sales charges, improving transparency through disclosure, encouraging retail price competition and modifying the oversight role of fund directors.
Capping Fund Sales Charges.
In order to cover marketing, distribution and other shareholder servicing costs, investors are often charged a sales charge (or load) when they purchase shares in a mutual fund. This sales charge can either be paid directly by the investors at the time of the purchase (a “front-end” sales charge) or indirectly by deducting it from the assets of the fund, thus reducing performance and investor returns over time (an “asset-based” sales charge). Front-end sales charges are currently limited to 8.5% by the Financial Industry Regulatory Authority (FINRA) and asset-based charges are also limited by FINRA to 0.75% of a fund’s assets per year. Asset-based fees may currently be charged throughout the life of the fund (although, in many cases, an investor’s holdings of a share class with relatively high 12b-1 fees will automatically convert after a period of time into a share class with lower 12b-1 fees).
The proposed rules would limit ongoing asset-based sales charges so that, over time, the cumulative amount of sales charges that an investor pays on any purchase of fund shares does not exceed the highest front-end load that the investor would have paid had the investor invested in another class of shares of the same fund, or if the fund does not offer a class of shares with a front-end load, the maximum sales charge rate permitted under the FINRA Conduct Rules (currently 6.25%). Funds would be provided a five-year grandfathering period after the compliance date of the new rules for share classes issued prior to such date and which charge asset-based fees pursuant to Rule 12b-1 as it exists today. After this grandfathering period such shares would be required to be converted or exchanged into a class that does not deduct an ongoing sales charge.
Funds will also be allowed to pay out of their assets an ongoing marketing and services fee, not to exceed 0.25% per year, in order to cover ongoing marketing, distribution and shareholder service expenses. This marketing and services fee may be charged indefinitely, and is not limited by reference to front-end sales charges. In addition, the proposed rules would not preclude funds from using this 0.25% fee for both distribution and non-distribution expenses, such as supermarket fees that include both distribution and non-distribution components (e.g., sub-accounting, administrative and account maintenance services). The proposed rules would also permit funds to charge as general fund administration expenses, expenses that can clearly be identified as non-distribution-related (such as sub-transfer agency fees), thus keeping asset-based distribution fees within the 0.25% limit of the new marketing and services fee. This would appear to continue the SEC’s previous position, as enunciated in the Charles Schwab no-action letter,1 of permitting the fund to determine that a portion of supermarket fees are for non-distribution purposes that need not be subject to Rule 12b-1.
Improving Transparency Through Disclosure.
The new rules aim to improve the transparency of distribution and marketing fees by abandoning the term “12b-1 fees” in exchange for “ongoing sales charge” and “marketing and services fees.” The rules also propose more detailed disclosure to investors. The SEC has explained that 12b-1 fees have generally been used to cover up-front marketing and sales costs, similar to a load, as well as subsequent marketing and servicing costs. Under the new rules, the term “ongoing sales charges” will be used to refer to the asset-based charges that serve as a substitute to up-front sales charges or loads and “marketing and services fees” will be used to describe asset-based charges that cover subsequent distribution, marketing and shareholder servicing expenses.
It is proposed that both the ongoing sales charges and the marketing and services fees be disclosed in the fee table of a mutual fund’s prospectus along with a description of the type and nature of the services associated with these fees. These items must also be disclosed in shareholder reports and on individual sales confirmations. Disclosure on individual sales confirmations must describe the total sales charges that an investor is being required to pay.
Encouraging Retail Price Competition.
The proposed rules would also allow funds to establish a share class that could be offered through broker-dealers who would be able to set their own commission and sales charge based on the level of services provided and then charge this fee directly to investors. Under the current rules, sales charges are determined by a fund and disclosed in its prospectus. Because shares must be sold in accordance with terms disclosed in a prospectus, broker-dealers have been unable to reduce the sales charge in an effort to gain competitive advantage as to sale of shares of a given fund. By the same token, however, investors are assured that the price they pay for a given fund will not vary depending on the intermediary they choose. The SEC has indicated that by allowing broker-dealers to compete on the basis of sales charges and services, the proposed rules are meant to provide a more level playing field for broker-dealers and funds of varying sizes as well as to place downward pressure on sales charges.
Modifying the Oversight Role of Fund Directors.
Under the current rules, a fund must adopt a written plan describing its use of asset-based sales charges. This plan must be approved initially by the board of directors and then renewed annually by the board. The SEC has observed, however, that once in place these plans are seldom changed due to the difficulty of altering such long-term arrangements and because obtaining shareholder approval of a material change can be costly and time-consuming. Under the proposed rules, directors would retain the ability to authorize the use of fund assets to finance distribution activities consistent with the limits of the rules and their fiduciary obligations to the fund and fund shareholders. However, because the proposed rules would establish specific limits on the amount of asset-based sales charges, directors will no longer be required explicitly to approve and re-approve such plans. Their oversight responsibilities over sales charges and marketing fees would be similar to their oversight responsibilities regarding the use of fund assets to pay any other fund operating expenses, particularly those that create a potential conflict of interest for the fund’s investment adviser or other affiliated persons. The SEC has indicated that it plans to provide guidance in the adopting release for the new rules, to assist fund directors in satisfying their fiduciary duties.
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