Alert July 27, 2010

SEC Proposes to Amend Rules Relating to Fees Paid for Marketing and Distribution of Mutual Fund Shares

The SEC recently proposed to eliminate Rule 12b-1 under the Investment Company Act of 1940 (the “1940 Act”), the rule that currently allows a registered open‑end investment company (a “mutual fund” or “fund”) to pay certain marketing and distribution expenses from the fund’s assets.  In its place, the SEC has proposed new Rule 12b-2 and amendments to Rule 6c-10, which would limit the amount of asset-based sales charges an investor would pay to acquire shares of a fund.  In addition, various amendments to rules under the 1940 Act and other federal securities laws, if adopted as proposed, would require a mutual fund to provide better disclosure of distribution fees, allow a fund to sell its shares through broker-dealers that establish their own sales charges, and eliminate the need for mutual fund directors to approve and annually reapprove fund distribution financing plans.

Summary of Proposed Rule Changes

  • Rescission of Rule 12b-1.  The proposed rule changes would rescind Rule 12b-1.  Rule 12b-1 generally 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 fund shares.  Without the rule, Section 12(b) of the 1940 Act would prohibit a mutual fund from acting as a distributor of its own shares, and the fund would have to rely on sales loads and the assets of its investment adviser and principal underwriter to compensate brokers for their selling activities.  Among other things, Rule 12b-1 requires that before a fund may pay for distribution expenses using fund assets, the fund must adopt a written plan describing all material aspects of financing of distribution, the plan must be approved initially and reapproved annually by the board as a whole and separately by the independent directors, and in some cases by the fund’ shareholders, and the fund must meet certain fund governance standards.  In order to approve or reapprove a 12b-1 plan, the fund’s directors generally are required to find that the plan is reasonably likely to benefit the fund and its shareholders.
    Rule 12b-1 does not limit the amount of fees that may be permitted by a 12b-1 plan, and it does not prohibit a fund from paying non-distribution related expenses under the plan.  NASD Rule 2830 (“Rule 2830”), however, prohibits a FINRA member broker-dealer from selling shares of a fund that pays more than 0.75% of fund assets as “asset-based sales charges,” or more than 0.25% of fund assets as “service fees.”  Rule 2830 also imposes an aggregate cap of 6.25% of a fund’s gross sales if the fund has an asset-based sales charge and charges a service fee, and imposes an aggregate cap of 7.25% of a fund’s gross sales if the fund does not charge a service fee.  The proposing release notes that the caps are intended to limit how much fund underwriters may receive not how much an individual shareholder may pay to acquire fund shares.

  • New Rule 12b-2.  New Rule 12b-2 would continue to permit funds to use fund assets to pay for distribution related activities, but subject to different limitations.  Unlike Rule 12b-1, proposed Rule 12b-2 would permit a fund, with respect to any class of shares, to deduct a “marketing and service fee” of up to the Rule 2830 “service fee” annual limit of 0.25%.  This marketing and service fee could pay for any distribution-related expense or servicing cost, without limitation on the amount of a sales load the fund could impose.  Proposed Rule 12b-2 would not require a written plan, board approval or re-approval, compliance with any fund governance standard, or any special board finding.  Shareholder approval, however, would be required to institute or increase any marketing and service fee on any existing class of shares.
    In the case of funds that invest in other funds (such as a fund-of-funds and a feeder fund in a master-feeder structure), proposed Rule 12b-2 would prohibit the total marketing and service fees charged by the acquiring and acquired funds, when added together, from exceeding the Rule 2830 service fee limit.  Funds underlying insurance company separate accounts would be treated for these purposes as any other acquired fund.

  • Amendments to Rule 6c-10.  Rule 6c-10 under the 1940 Act generally permits a mutual fund to charge a deferred sales load on any class of fund shares.  The SEC is proposing to amend Rule 6c-10 to permit a fund to charge a fund-level sales charge, that is, to permit it to deduct from fund assets amounts in excess of the Rule 12b-2 marketing and service fees, and treat the excess amount, which the proposed amended rule refers to as the “ongoing sales charge,” as another form of sales load.  Under the proposed amendments to Rule 6c-10, the treatment of deferred sales loads generally would remain the same.
    The proposed amended rule would limit the amount of all sales charges that an investor would pay in any form, that is, the sum of all front-end, deferred and asset-based sales charges paid by the investor, to the highest sales load rate that the shareholder would have paid if the shareholder had purchased a class offered by the fund that does not have an ongoing sales charge, or, if the fund does not offer such a class, the maximum sales charge rate permitted under Rule 2830 for a fund that deducts an asset-based sales charge and a service fee (currently, 6.25%).  At the time the amount of all sales charges paid by an investor reached the limit, all sales charges would have to cease or the investor’s shares would have to convert to class that does not apply a sales charge.For funds that invest in other funds, the acquiring fund and the acquired fund could not both charge an ongoing sales charge of any amount.  Funds underlying insurance company separate accounts would be treated for these purposes like any other acquired fund.The proposed amendments to Rule 6c-10 also would permit a fund to offer a share class as to which, in lieu of any asset-based sales charge established by the fund’s underwriter, fund intermediaries could impose charges for sales of fund shares at negotiated rates.  In order to offer such a share class, the fund would have to disclose in its prospectus that it has elected to rely on the applicable section of Rule 6c-10 (as proposed to be amended).  Once a fund has offered any shares of such a class, the fund could not include or raise any ongoing sales charge with respect to that class, even with shareholder approval.As with proposed Rule 12b-2, the proposed amendments to Rule 6c-10 would not require a written plan, board or shareholder approval or re-approval, compliance with any fund governance standard, or any special board finding.  The proposing releases notes that a fund’s board would continue to have a fiduciary duty as provided under Section 36(a) of the 1940 Act and state law with respect to its oversight of the use of fund assets. 

  • Amendments to Rule 10b-10.  Rule 10b-10 under the Securities Exchange Act of 1934 (the “1934 Act”) generally requires broker-dealers to disclose on customer trade confirmations certain information about the transaction being confirmed, including the price of the security at which the transaction was effected and the commissions and other remuneration paid by customers to broker-dealers and certain third parties.  The SEC currently permits broker-dealers to omit from confirmations of mutual fund transactions information relating to sales charges and payments to third parties, provided that the customer receives a fund prospectus that adequately discloses that information.  The SEC is proposing amendments to Rule 10b-10 to require disclosure in customer trade confirmations of, among other things, all front-end and deferred sales charges, ongoing sales charges and marketing and service fees, in percentage and dollar terms, the net amount invested in the fund at the time of purchase, and the amount of any applicable breakpoint or similar threshold used to calculate the sale charge.  Confirmations of share redemptions would be required to disclose the amount of any deferred sales charge that the customer has incurred or may be expected to incur, expressed in dollars and as a percentage of the fund’s net asset value at the time of purchase or redemption, as applicable.
  • Certain Other Conforming Amendments.  Other amendments to existing SEC rules and forms include:
  • Form N-1A, the registration form for mutual funds under the Securities Act of 1933 and the 1940 Act.
    • Item 3 - the prospectus fee table, which currently requires identification of 12b-1 fees, would require identification of any ongoing sales charges and marketing and service fees, both of which would be reflected as expenses that shareholders would pay indirectly;
    • Item 19(g)(1) - the current requirement to describe a fund’s 12b‑1 plan in its Statement of Additional Information (“SAI”) would be replaced with a requirement to disclose the principal activities paid for through ongoing sales charges and marketing and service fees;
    • Item 25 - the current requirement to provide information in a fund’s SAI concerning the distribution of fund shares would be amended to accommodate the required disclosure for a fund that offers a share class as to which fund intermediaries may impose charges for sales of fund shares at negotiated rates.
    • Schedule 14A under the 1934 Act - funds soliciting proxies using Schedule 14A would, among other things, no longer be required to disclose information concerning 12b-1 plans but would be required to disclose information concerning marketing and service fees.
    • Rule 11a-3 under the 1940 Act - Rule 11a-3 which permits a sales load to be charged on shares acquired in certain exchanges between funds in the same fund group under certain conditions, would be amended to, among other things, treat ongoing sales charges as a sales load.
    • Expected Transitioning.  Under the SEC’s proposal, if adopted, the proposed rule changes would become effective within 60 days of the date that the adopting release is issued, and funds would be expected to comply with the amendments for new shares sold beginning no later than 18 months after the effective date.  The SEC also has proposed a five-year grandfathering period for share classes deducting fees pursuant to Rule 12b‑1 that issued shares prior to the compliance date.  Under the grandfathering provision, by the date five years after the compliance date, a grandfathered share class would have to have converted or exchanged into a class that does not deduct an ongoing sales charge.  New sales of a grandfathered share class would not be permitted after the compliance date.

    Issues on Which the SEC is Seeking Public Comment

    The SEC has requested comments on the following issues, among others:

    • The appropriate level and uses of marketing and service fees under proposed Rule 12b-2;
    • The operational implications of the proposed automatic conversion of shares once the shareholder has paid the maximum amount of sales charges under proposed amended Rule 6c-10;
    • Whether there should be a maximum limit on the amount of ongoing sales charges that may be deducted, or should fund boards be assigned the responsibility of establishing that maximum limit and if so, what should be the standards or factors relevant to their determination;
    • Whether Rule 6c-10 should permit the Rule 2830 maximum sales charge (i.e., 6.25%) to serve as the default reference for funds that do not offer a class of shares without an ongoing sales charge;
    • Whether dividends and other distributions should be invested in a share class without an ongoing sales charge;
    • Whether the proposed approach to the role of a fund’s board in overseeing asset-based distribution fees is appropriate;
    • Whether the information included in mutual fund trade confirmations is useful to investors and if not, how it should be improved;
    • The appropriateness of the proposed approaches regarding marketing and sales fees and ongoing sales charges in the context of funds that invest in other funds;
    • Whether funds underlying insurance company separate accounts should be treated differently than other types of mutual funds;
    • Advantages and disadvantages of externalizing sales charges;
    • The placement and accuracy of the proposed disclosure regarding marketing and sales fees and ongoing sales charges; and
    • Whether the SEC should require account statements to include disclosure of the actual dollar amount of asset-based distribution fees.

    Deadline for Comments.  The SEC has stated that comments on the proposed rule changes must be received no later than November 5, 2010.