The Securities and Exchange Commission (the SEC) has proposed a new rule and rule amendments that would replace Rule 12b-1 under the Investment Company Act of 1940 (ICA) with a new regulatory framework governing how mutual funds may use fund assets to finance distribution and marketing costs (the Proposal)[1]. In the Proposing Release, the SEC stated that the Proposal was designed to “protect individual investors from paying disproportional amounts of sales charges, promote better investor understanding of fees, eliminate outdated requirements, provide a more appropriate role for fund directors and introduce greater competition among funds in setting sales loads and distribution fees generally.” A summary of the key elements of the Proposal is set forth below:

Rule 12b-1 would be rescinded. Currently, Rule 12b-1 permits funds to use their assets to pay broker-dealers and others for providing services that are primarily intended to result in the sale of fund shares. Often these fees are used to pay for advertising and general marketing, as well as compensation of intermediaries who sell fund shares. The SEC noted in the Proposal that a majority of funds have adopted Rule 12b-1 plans and acknowledged the significant role Rule 12b-1 fees play in paying fund distribution costs; however, the SEC indicated that it was proposing to rescind Rule 12b-1 after considering information gathered at roundtable discussions and from a number of comment letters received. Under the Proposal, Rule 12b-1 would effectively be replaced with the following new fees:

  • New Rule 12b-2 Marketing and Service Fees. A new proposed Rule 12b-2 under the ICA would allow funds to deduct from fund assets what the SEC calls a “marketing and service fee” up to the maximum rate of the service fee permitted under NASD Conduct Rule 2830 (currently 25 basis points annually). This marketing and service fee could be used for any legitimate distribution-related activity including, without limitation, (i) follow-up services provided by brokers and other intermediaries after the sale has been made; and (ii) a fund’s participation in distribution channels that offer investors a convenient way of buying shares, such as fund supermarkets and retirement plans. Under the Proposal, mutual fund boards would not be required to adopt a 12b-2 plan or annually approve its continuance.
  • New Ongoing Sales Charges. Proposed amendments to Rule 6c-10 under the ICA would permit funds to deduct asset-based distribution fees in excess of the Rule 12b-2 marketing and service fee in the form of a so called “ongoing sales charge” with the following characteristics:
    • Ongoing sales charge limits. The ongoing sales charge would be treated like a deferred sales charge, subject to certain limitations. These limitations include limiting the aggregate ongoing sales charges assessed to the investor to no more than the highest front-end load that the investor would have paid if he or she invested in another class of shares in the same fund or, if none, the aggregate sales load maximum charge limit set forth in NASD Conduct Rule 2830(d)(2)(A) (currently 6.25% of the amount invested).[2]
    • Automatic conversion and individual calculation. The investor would be automatically converted to a class of shares without an ongoing sales charge no later than when the investor has paid cumulative aggregated allowed changes.[3] Thus, the ongoing sales charge would be capped at a shareholder account-level instead of the fund-level cap currently used under the NASD sales charge rule for funds with an asset-based sales charge and service fee.[4]Like the proposed Rule 12b-2 fees, mutual fund boards would not be required to adopt a “plan” or annually approve its continuance.

A new Account Level Sales Charge Alternative would be allowed. As an alterative to an ongoing sales charge, proposed amendments to Rule 6c-10 would allow funds to sell their shares (all their shares or any class of shares) through dealers at net asset value (without a sales load) and dealers could impose their own sales charge in the form an “account-level sales charge.” This type of sales charge could vary in amount or time and payment. The SEC indicated that some of benefits from this type of sales charge would include enhanced competition in fund distribution, greater transparency of distribution charges and reduced conflicts for broker-dealers selling funds with different compensation structures. Funds electing this alternative could also charge the Rule 12b-2 marketing and service fee.

Trade Confirmations would be required to include sales charges and fee information. The Proposal includes amendments to Rule 10b-10 under the Securities Exchange Act of 1934 that would require the inclusion of additional information on mutual fund trade confirmations, including information on sales charges and fees so that investors can more fully understand the sales changes they incur and verify whether they paid the correct sales charge.

Various form disclosures would be amended to reflect the new asset based fee approach. The Proposal calls for various disclosure changes, including more disclosure in fund prospectuses and SAIs of the use and amount of asset-based distribution fees being deducted by funds, removing requirements that would be outdated, and conforming other disclosures with the new rules.

An eighteen month transition with a five year grandfathering period would be provided. The Proposal indicates that there would be a transition period of a least 18 months for funds to come into compliance with the new rules. In addition, for shares issued prior to the compliance date, a five year grandfathering period would be allowed during which funds could continue to deduct fees from such shares pursuant to current Rule 12b-1. After the grandfathering period, those shares would be required to be convert or exchanged into a class of shares that does not include a ongoing sale charge and otherwise become into compliance with the new rules.

Shareholder approval would be required for new or increased fees. Under the Proposal, shareholder approval would be required to adopt new fees or increase existing fees, but approval would not be required where the combined ongoing sales charge and marketing and service fee does not exceed amounts deducted under Rule 12b-1 in effect at the time the new rules become effective.

Due to the current widespread use of, and reliance on, Rule 12b-1 fees in the mutual fund industry, we expect the Proposal to generate significant debate and to be the subject of many comments in the coming weeks. The proposed rules are open for public comment until November 5, 2010.