SEC Proposes Changes to Structure for Mutual Fund Distribution Fees

The Securities and Exchange Commission ("SEC") on July 21, 2010 voted unanimously to propose a new rule and rule amendments that would replace rule 12b-1 under the Investment Company Act of 1940 (the "1940 Act"), changing the framework through which funds may use fund assets to pay for the costs of distribution.1 The SEC states that the proposals are designed to protect individual investors from paying disproportionate amounts of sales charges in certain share classes and to promote investor understanding of fees.

As discussed in greater detail below, the proposals would:

Rescind rule 12b-1; Permit funds to deduct a fee of up to 0.25% annually from fund assets to pay for distribution activities (the "marketing and service fee"); Permit funds to deduct asset-based distribution fees in excess of the marketing and service fee, provided that the excess is treated as a sales charge subject to certain maximums (the "ongoing sales charge"); Eliminate the need for special board findings, a written plan, annual renewal or automatic termination provisions or the need to meet specified fund governance requirements; Implement new disclosure requirements in transaction confirmations, registration statements and other fund disclosure documents designed to provide investors with additional transparency about the marketing and service fee, ongoing sales charges and other sales charges; and Permit an alternative distribution model that would allow fund intermediaries to impose charges at negotiated rates in connection with sales of fund shares (the "account-level sales charge"). Rescission of Rule 12b-1

The Proposing Release provides an extensive discussion of the administrative history of rule 12b-1, including the SEC staff's current perspective on the purpose of rule 12b-1. The Proposing Release takes the position that many of the original assumptions underlying rule 12b-1 no longer reflect current market realities, noting in particular the role that 12b-1 fees play in fund distribution, director responsibilities in considering whether to approve 12b-1 fees, and potential investor confusion about rule 12b-1. In this spirit, the proposals would rescind rule 12b-1 in its entirety2 and put forth a new regulatory framework to address the use of fund assets to pay for distribution costs.

Limits on Asset-Based Distribution Fees

Marketing and Service Fees

Proposed rule 12b-2 would permit funds to deduct from fund assets a "marketing and service" fee of up to the FINRA service fee limit (currently 0.25% of net assets annually)3 to pay for distribution activities. Proposed rule 12b-2 would not confine the use of marketing and service fees to the types of services described in NASD Conduct Rule 2830, recognizing that certain shareholder services may have a distribution component. Rather, funds would be able to use these fees to pay for any distribution activity.4 Proposed rule 12b-2 defines "distribution activity" to mean any activity which is primarily intended to result in the sale of shares issued by a fund, including, but not necessarily limited to, advertising, compensation of underwriters, dealers, and sales personnel, the printing and mailing of prospectuses to other than current shareholders, and the printing and mailing of sales literature. The Proposing Release provides that the marketing and service fee may also be used to pay for the costs of participating in fund supermarkets, trail commissions paid to broker-dealers in recognition of ongoing services they provide to investors, or payments to retirement plan administrators for services they provide to plan participants that relieve the fund from providing such services.

Under the proposals, any asset-based charge for distribution in excess of the FINRA service fee limit (0.25% of net assets annually) would be considered an ongoing sales charge and subject to the sales charge limitations established by FINRA5 and by rule 6c-10 (as amended by the proposals and discussed below). The SEC chose this limit to "distinguish a limited distribution fee from a sales charge."

Proposed rule 12b-2 would require a fund to obtain shareholder approval before it could institute, or increase the rate of, a marketing and service fee after any public offering of the fund's securities. Shareholder approval, however, would not be necessary for a fund to institute a marketing and service fee with respect to a new class or series of shares. In this regard, the Proposing Release explains that, because rule 12b-1 currently requires shareholder approval to adopt a 12b-1 plan or materially increase the amount paid under the plan, proposed rule 12b-2 would not "significantly change the rights of fund shareholders or the obligations of funds and fund underwriters."

Unlike rule 12b-1, proposed rule 12b-2 would not require the adoption of a formal distribution plan and instead would rely on the structural limits on the marketing and service fee embedded in the proposal.6

Ongoing Sales Charges

In addition to the marketing and service fee, a fund would be permitted to impose an asset-based ongoing sales charge. The proposed amendments to rule 6c-107 would permit funds to deduct an asset-based charge for distribution in excess of the marketing and service fee permitted by rule 12b-2, which excess fees would be considered an "ongoing sales charge" subject to certain restrictions.

Maximum Sales Charge Rate. Under proposed amended rule 6c-10, a fund may deduct an ongoing sales charge from fund assets if the cumulative ongoing sales charges imposed on a purchase of fund shares do not exceed the shareholder's maximum sales load. The proposal provides that a fund may satisfy this requirement by converting the shares into shares not subject to an ongoing sales charge on or before the end of a conversion period. The length of the conversion period would be calculated by a formula that utilizes the highest sales load rate that the shareholder would have paid as a front-end sales load to purchase fund shares.

Under the proposed approach, a fund could impose an ongoing sales charge if the cumulative rate of the ongoing sales charge, when combined with the rate of any front-end or deferred sales loads to be imposed on an investor's purchase of fund shares, would not exceed the rate of the highest front-end sales charge that the investor would have paid if investing in another class of shares of the same fund that does not have an ongoing sales charge (the "reference load").8 For example, if a fund offers Class A shares that have a 4.50% maximum front-end sales load, another class of shares that does not impose a front-end sales charge could impose ongoing sales charges totaling 4.50%.

The SEC states in the Proposing Release that the proposed approach is designed to reduce the potential that some long-term shareholders will pay a significantly disproportionate share of a fund's distribution costs. The Proposing Release makes the additional point that, to the extent competitive pressures result in lower front-end sales charges, classes with ongoing sales charges would benefit from lower overall ongoing sales charges. Under proposed amended rule 6c-10, funds would not be required (but would be permitted) to apply breakpoints or scheduled variations in front-end sales loads when determining the reference load. This aspect of the proposal reflects the SEC's concern that such a requirement (which would reduce the level of the reference load) would create greater complexity and cost and, in the SEC's view, could inhibit the use of breakpoints or scheduled variations.

Automatic Conversion of Shares. Shares subject to an ongoing sales charge would be required to convert automatically to another class of shares that does not impose an ongoing sales charge, with the conversion taking place no later than the end of the month during which the cumulative ongoing sales charge rate paid by the investor exceed the investor's maximum sales load rate.9 For example, if a fund's maximum sales load rate is 4.50%, the fund could impose an ongoing sales charge of 0.50% for up to nine years, 0.75%...