The SEC on July 21, 2010 proposed rule changes designed to significantly reform the regulation of distribution fees paid by mutual funds.¹ Under the proposal, the SEC would replace existing Rule 12b-1 under the Investment Company Act of 1940 (“1940 Act”) with new Rule 12b-2. In addition, the SEC would amend certain related rules and forms. Currently, Rule 12b-1 allows distribution fees to be deducted from mutual fund assets.

Under new Rule 12b-2, fund sponsors would continue to be able to offer funds that bear promotional, marketing and other distribution costs in addition to imposing sales-related charges at the time of purchase. Under proposed revisions to Rule 6c-10, funds would be allowed to change ongoing sales charges subject to a maximum limit. The proposed rules would make a number of significant changes, including: additional disclosure about sales charges in a fund’s prospectus, annual and semi-annual reports and investor confirmation statements; revised fund director oversight duties; and the ability of funds to permit dealers to set and propose their own sales charges under certain circumstances.

New Rule 12b-2

Under the SEC’s proposal, Rule 12b-1 would be rescinded in its entirety and replaced with Rule 12b-2. That rule would split distribution fees into two categories: (i) marketing and service fees and (ii) ongoing sales charges.

Marketing and Service Fees

Under Rule 12b-2, a fund could pay an asset-based fee for “distribution activities.” This fee would be called a “marketing and service fee.” A fund could charge a marketing and service fee up to the service fee limit imposed by NASD Conduct Rule 2830, which is currently 25 basis points annually. A fund could use this fee to pay any distribution activity (in contrast to NASD Conduct Rule 2830, which limits the types of expenses that qualify for payment as service fees).

Proposed Rule 12b-2 defines “distribution activity” broadly 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.” In the Proposing Release, the SEC gave the following examples of the way a fund could use marketing and service fees:

• pay costs associated with participation on a distribution platform, such as a fund “supermarket,”
• pay trail commissions to broker-dealers in recognition of the ongoing services they provide to fund investors,
• pay retirement plan administrators for services provided to participants,
• offset the costs of shareholder call centers,
• pay servicing fees like those currently permitted by FINRA rules, and
• traditional distribution-related services.

The SEC in the Proposing Release stated that a fund could use the marketing and service fee to pay for non-distribution-related services, such as sub-transfer agency type services. Alternatively, a fund could elect to not categorize non-distribution-related expenses as a marketing and service fee and pay for such expenses using fund assets.

Ongoing Sales Charges

The second prong of the revised distribution proposal creates the “on-going sales charges” category by amending Rule 6c-10 under the 1940 Act to permit funds to deduct asset-based distribution fees in excess of the annual 25 basis point limit on marketing and service fees, subject to certain cumulative limits. The cumulative amount of on-going sales charges together with any other sales charges could not exceed, in percentage terms, the highest front-end sales load imposed by a share class of the same fund that does not impose an ongoing sales charge (the “reference load”). If a fund does not have such a share class, the reference load would be the maximum amount permitted under NASD Conduct Rule 2830 for funds that impose an asset-based sales charge and a service fee, which is currently 6.25%. Subject to these limits, funds could continue to charge a front-end sales load or a contingent deferred sales load together with an ongoing sales charge.

The SEC gave the following example in the Proposing Release illustrating how this aspect of the new rule would work. If a fund has class A shares with a 6% front-end sales load, the fund could pay as much as 6% in total ongoing sales charges in class B shares. If another class of shares charges a front-end sales load of 2%, a total ongoing sales charge of as much as 4% could also be charged (6% minus the 2% front-end load) with respect to that class.

Shareholder Account-Level Fee Limits

One of the most significant changes to the distribution fee regulatory scheme would be that the sales charge limit would be based on the cumulative amount of sales charges that an individual investor pays. This approach differs from the current fund-level approach, which limits how much fund underwriters may collect in asset-based sales charges. In short, the SEC proposes to replace the current fund-level or share-class-level cap with a shareholder account-level cap.

Funds would be required to track purchases by shareholder. Each purchase or “lot” would have to be tracked separately. If a shareholder transferred from one fund intermediary to another, the new intermediary would have to track the shares, including accounting for the shares being held at the shareholder’s former intermediary.

Under the proposal, a fund would have the option of not having to track the actual dollar amounts of the ongoing sales or other charges incurred by each individual shareholder account. Rather, a fund could implement a system in which shares purchased would automatically convert to another share class without an ongoing sales charge by the end of the month during which the fund would have paid on behalf of the shareholder the maximum amount of permitted sales charges based on the cumulative rates charged each year. In addition, a fund could impose a contingent deferred sales load (“CDSL”) in combination with an ongoing sales charge, but total sales charges could not exceed the maximum sales charge limitation.

Building on its example set forth above, the SEC stated that a fund offering class A shares with a 6% front-end load could also offer class B shares that are subject to an annual ongoing sales charge of 0.75% with a declining CDSL. The maximum CDSL that the fund could charge on a purchase of class B shares would be 5.25% in the first year, 4.5% in the second year, 3.75% in the third year, and so forth. At the end of the eighth year following the purchase, the fund would be required to convert the class B shares to a share class that does not charge an ongoing sales charge. Thus, regardless of when the shareholder redeems shares, the shareholder’s total sales load rate would never exceed 6%, the maximum class A front-end load rate.

The maximum number of months a shareholder could remain invested in a class of shares paying an ongoing sales charge would depend both on the maximum sales load and the rate of the ongoing sales charge. Thus, for example, if the maximum sales load for the fund is 3%, the ongoing sales charge could be 50 basis points annually for six years. Alternatively, for example, the fund could collect 25 basis points annually for 12 years, 75 basis points annually for four years or 150 basis points annually for two years.

Board’s New Role with Respect to Distribution Fees

The SEC’s proposal, if adopted, would substantially reduce the duties imposed on fund board members with respect to distribution fees by eliminating certain provisions that have required boards to take certain actions and make special findings.

The board of directors of a fund would have the ability to authorize the use of fund assets to finance distribution activities without having to adopt a plan related to a marketing and service fee or make any special findings regarding this fee. Rather, a board would authorize such an arrangement pursuant to its fiduciary obligations to the fund and fund shareholders.

Consistent with directors’ fiduciary duties, fund boards could authorize ongoing sales charges without adopting a plan. The SEC stated in the Proposing Release that the Board would have to consider whether an ongoing sales charge is in the best interests of a fund and its shareholders and it provided in the Release guidance to fund directors with respect to making this determination.

In general, a fund’s board would view the ongoing sales charges and marketing and service fees as integral parts of a fund’s underwriting arrangement and assess those distribution fees in the context of the fund’s underwriting contract. Prior to giving approval, the SEC stated in the Proposing Release that, directors should determine, among other things, whether:

• the contract benefits the fund and its shareholders,
• the underwriter’s compensation is fair and reasonable, and
• any sales charges, including an ongoing sales charge, are “fair and reasonable in light of the usual and customary charges made by others for services of similar nature and quality.”

Shareholder Approval

Rule 12b-2 would require a fund to seek shareholder approval prior to instituting or increasing a marketing and service fee. Funds seeking to implement a marketing and service fee would not be required to obtain shareholder approval if:

• the fund currently is subject to a Rule 12b-1 fee that is 25 basis points or less and the fee rate is not increased; or
• the fund reduces its Rule 12b-1 fee to 25 basis points or less and renames the fee a “marketing and service fee.”

Disclosure

The SEC’s proposal would require mutual funds and broker-dealer to disclose their use of marketing and service fees and ongoing sales charges as follows.

Mutual Funds

A fund that imposes ongoing sales charges and marketing and service fees would have to disclose such fees under new headings in its prospectus. A new heading, “Ongoing Sales Charges,” would appear in the fee table in a fund’s prospectus in the place of the current heading “Distribution [and/or Service] (12b-1) Fees.” A new sub-heading, “Marketing and Service Fee” would appear as a separate category of “Other Expenses” under the sub-heading “Marketing and Service Fee. Funds would have to disclose the rates of these fees and the purposes for which they are used. If these fees were charged for services provided to fund investors, a fund also would be required to describe the nature and extent of those services. In addition, funds also would be required to disclose the number of months or years after which the shares would automatically convert to a share class without an ongoing sales charge. Outside of the fee table, funds would be required to describe any marketing and service fees and/or ongoing sales charges, and the principal activities for which they are used.

Funds also would be required to disclose marketing and service fees and ongoing sales charges in the financial statements. The SEC has also proposed certain disclosure requirements governing proxy statements.

Broker-Dealers

Under the SEC’s proposal, confirmation statements on mutual fund share transactions would have to describe marketing and service fees, ongoing sales charges, and other charges. Such disclosure would include:

• the amount of any front-end sales charge in percentage and dollar terms, together with the net dollar amount invested and any applicable breakpoints;
• the maximum amount of any deferred sales charge, as a percentage of net asset value at time of purchase or redemption;
• the annual amount of any marketing and service fees or ongoing sales charges and the aggregate amount of ongoing sales charges that may be incurred over time, both expressed as a percentage of net asset value, and the maximum number of months or years that the investor will pay ongoing sales charges;
• a statement to the effect that the investor will indirectly pay other asset-based fees charged by the fund, such as management fees, in addition to any marketing and service fees or ongoing sales charges; and
• the amount of any deferred sales charge incurred or to be incurred, expressed in dollars and as a percentage of net asset value, in the case of redemptions.

The SEC’s proposal also addresses what may be disclosed in periodic shareholders statements in lieu of confirmations with respect to investment company plans, periodic plans and money market mutual funds.

Section 22(d)

As part of its distribution fee reform, the SEC also addressed Section 22(d) of the 1940 Act, which requires fund shares to be sold only at the price set forth in the fund’s prospectus. This statutory provision effectively fixes the price of fund shares. The SEC’s proposal would amend Rule 6c-10 under the 1940 Act to provide an exemption from Section 22(d) to allow funds to offer their shares without a front-end sales charge at net asset value and to allow dealers in those shares to set and impose their own sales charges. The amount of dealer-imposed charges, and the manner and timing of their collection, would be left up to the dealers, subject to applicable FINRA rules.

Funds of Funds

In a fund of funds arrangement, both an acquiring and the acquired fund would be permitted under the SEC’s proposal to charge a marketing and service fee. The cumulative fees charged by both funds could not exceed 25 basis points per year. Either of the acquiring fund or the acquired fund, but not both, would be permitted to impose an ongoing sales charge.

Other Rule Amendments

The SEC also proposed amendments to a number of other rules in connection with its distribution fee regulation proposal:

• Rule 11a-3, which governs exchanges between funds within the same fund complex, currently limits the total combined sales load incurred on both the exchanged and acquired shares, as well as the amount and timing of permissible deferred sales loads. Rule 11a-3 would be amended to reflect that, under the SEC’s proposal, ongoing sales charges are treated similarly to sales load by giving shareholders credit for ongoing sales charges paid with respect to the shares being exchanged.
• Rule 17a-8, which allows funds to merge with affiliated funds without first receiving an exemptive order from the SEC and without shareholder approval, would be amended to address the Rule’s current condition that Rule 12b-1 fees of the surviving fund may not be greater than those imposed by the merging fund. The SEC’s proposal simply would replace the current reference to Rule 12b-1 fees with references to marketing and service fees, ongoing sales charges, and grandfathered Rule 12b-1 fees.
• Rule 17d-3, which permits a fund to enter into distribution-related agreements with certain affiliates and the principal underwriter to facilitate a Rule 12b-1 plan, would be amended to replace the current reference to Rule 12b-1 with references to the rules governing marketing and service fees, ongoing sales charges, and grandfathered Rule 12b-1 fees.
• Rule 18f-3, which permits funds to offer multiple classes of shares, would be amended to replace the current reference to Rule 12b-1 with references to the rules governing marketing and service fees, ongoing sales charges, and grandfathered Rule 12b-1 fees.

Effective Date, Compliance Period and Grandfathering

The effective date for Rule 12b-2 and the other proposed amendments, if adopted, would be 60 days after the publication of the adopting release in the Federal Register. However, the SEC’s proposal has a lengthier compliance period. With respect to sales of new shares, funds would be allowed a period of 18 months after the effective date to comply with the new rule and amendments. After this period, any shares issued by a fund would be required to comply with the new rule and amendments. Shares issued that are subject to Rule 12b-1 fees would be allowed a five-year grandfathering period after the compliance period has ended. New sales in 12b-1 shares would not be allowed after the end of the 18-month compliance period. The SEC’s proposal also addresses changes to Rule 12b-1 fees during the five-year grandfathering period.

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¹ See Investment Company Release No. 29367 (“Proposing Release”).