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Citing a need to better protect and inform mutual fund investors, the Securities and Exchange Commission (“SEC”) proposed on July 21, 2010 to replace Rule 12b-1 under the Investment Company Act with new rules governing asset-based distribution fees and related disclosure in fund prospectuses, annual and semi-annual reports to shareholders and investor confirmation statements.
Rule 12b-1 allows a mutual fund pursuant to a written “12b-1 plan” that is approved by the fund’s board of directors to use fund assets to pay for activities related to the distribution of the fund’s shares. The adoption of the Rule in 1980 contributed to a shift away from a traditional model of mutual fund investors paying for intermediaries’ services at the time of share purchase (i.e., paying a “front-end sales load”) to the 12b-1 model of mutual funds paying sales charges and other fees out of fund assets on an ongoing basis.
Under the proposal, mutual funds would continue to be able to compensate intermediaries using fund assets, but new limitations as to the cumulative amount of such fees and charges would apply.
The proposal divides these asset based fees into “marketing and service fees” of less than 0.25% per annum and higher “ongoing sales charges.” Marketing and service fees could be paid out of fund assets for distribution-related expenses such as participation in fund supermarkets, maintenance of shareholder accounts and marketing and distribution strategies, up to the amount allowed for funds to be described as “no load” under NASD Conduct Rule 2830 (currently 0.25% per year). A formal “plan” would not be required to be adopted by the fund’s board of directors, but shareholder approval would be required before a fund could institute or increase the rate of a marketing and service fee.
Ongoing sales charges are payments out of fund assets in excess of the marketing and service fees. Such charges would be treated like a sales load and limited, cumulatively, to the highest front-end sales load charged for that fund (or in the absence of a share class with a front-end sales load, a NASD rule-based 6.25% aggregate cap). A fund that has ongoing sales charges may satisfy its obligations to observe this limit by automatically converting to a class of shares with no ongoing sales charge once this cap has been reached. Ongoing sales charges could not be instituted or increased after any public offering of the fund’s voting shares or the sale of such shares to persons who are not organizers of the fund.
The proposal also would allow funds and their underwriters to offer share classes to be sold by intermediaries, such as broker-dealers, that could impose their own sales charges or commissions. This would allow intermediaries to compete on the basis of sales charges, just as brokers today charge competitive commissions for transactions in ETFs and other equity securities.
The proposal also increases disclosure. It would amend Rule 10b-10 under the Securities Exchange Act to require, among other items, disclosure of front-end and deferred charges as well as ongoing sales charges and marketing and service fees by broker-dealers in confirmations relating to mutual fund security transactions. Certain other changes to Rule 10b-10 concerning callable debt securities are also proposed.
The SEC states in a footnote that it is considering whether to require point of sale disclosure for mutual fund purchases based on new authority in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The SEC also proposed amendments to Form N-1A, including to require the separation of asset-based distribution fees into ongoing sales charges and marketing and service fees, and amendments to Investment company Act Rules 11a-3, 17a-8, 17d-3, 18f-3 and Forms N-3, N-4, N-6 and N-SAR, Regulation S-X and Schedule 14A.
If adopted, the proposal would have a profound impact on the economics of mutual fund distribution by broker-dealers and other intermediaries. Davis Polk is preparing a more comprehensive memorandum on the proposal and its potential effects that will be available to clients in the near future.
The proposal’s comment period ends November 5, 2010.
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