[Federal Register Volume 75, Number 149 (Wednesday, August 4, 2010)]
[Proposed Rules]
[Pages 47064-47139]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-18305]
[[Page 47063]]
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Part II
Securities and Exchange Commission
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17 CFR Parts 210, 239, 240 et al.
Mutual Fund Distribution Fees; Confirmations; Proposed Rule
Federal Register / Vol. 75 , No. 149 / Wednesday, August 4, 2010 /
Proposed Rules
[[Page 47064]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 210, 239, 240, 249, 270, and 274
[Release Nos. 33-9128; 34-62544; IC-29367; File No. S7-15-10]
RIN 3235-AJ94
Mutual Fund Distribution Fees; Confirmations
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``SEC'' or ``the
Commission'') is proposing a new rule and rule amendments that would
replace rule 12b-1 under the Investment Company Act, the rule that has
permitted registered open-end management investment companies (``mutual
funds'' or ``funds'') to use fund assets to pay for the cost of
promoting sales of fund shares. The new rule and amendments would
continue to allow funds to bear promotional costs within certain
limits, and would also preserve the ability of funds to provide
investors with alternatives for paying sales charges (e.g., at the time
of purchase, at the time of redemption, or through a continuing fee
charged to fund assets). Unlike the current rule 12b-1 framework, the
proposed rules would limit the cumulative sales charges each investor
pays, no matter how they are imposed. To help investors make better-
informed choices when selecting a fund that imposes sales charges, the
Commission is also proposing to require clearer disclosure about all
sales charges in fund prospectuses, annual and semi-annual reports to
shareholders, and in investor confirmation statements.
As part of the new regulatory framework, the Commission is
proposing to give funds and their underwriters the option of offering
classes of shares that could be sold by dealers with sales charges set
at competitively established rates--rates that could better reflect the
services offered by the particular intermediary and the value investors
place on those services. For funds electing this option, the proposal
would provide relief from restrictions that currently limit retail
price competition for distribution services.
The proposed rule and rule amendments are designed to protect
individual investors from paying disproportionate amounts of sales
charges in certain share classes, promote investor understanding of
fees, eliminate outdated requirements, provide a more appropriate role
for fund directors, and allow greater competition among funds and
intermediaries in setting sales loads and distribution fees generally.
DATES: Comments must be received on or before November 5, 2010.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml);
Send an e-mail to [email protected]. Please include
File Number S7-15-10 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Elizabeth Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-15-10. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for Web site viewing and printing in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549, on official business days between the hours of 10 a.m. and 3
p.m. All comments received will be posted without change; we do not
edit personal identifying information from submissions. You should
submit only information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: With respect to rules and forms under
the Investment Company Act and Securities Act, Thoreau A. Bartmann,
Senior Counsel, Daniel Chang, Attorney, or C. Hunter Jones, Assistant
Director, at 202-551-6792, Office of Regulatory Policy, Division of
Investment Management, Securities and Exchange Commission, 100 F
Street, NE., Washington, DC 20549-8549.
With respect to rule 10b-10 under the Securities Exchange Act,
Daniel Fisher, Branch Chief, or Ignacio Sandoval, Attorney, at 202-551-
5550, Office of Chief Counsel, Division of Trading and Markets,
Securities and Exchange Commission, 100 F Street, NE., Washington, DC
20549-7010.
SUPPLEMENTARY INFORMATION: The Commission is proposing to rescind rule
12b-1 [17 CFR 270.12b-1] under the Investment Company Act of 1940
(``Investment Company Act'' or ``Act'').\1\ The Commission is also
proposing for comment: New rule 12b-2 [17 CFR 270.12b-2] under the
Investment Company Act; amendments to rules 6c-10 [17 CFR 270.6c-10]
and 11a-3 [17 CFR 270.11a-3] under the Investment Company Act;
amendments to Form N-1A\2\ under the Investment Company Act and the
Securities Act of 1933 (``Securities Act''); \3\ amendments to rule 6-
07 [17 CFR 210.6-07] of Regulation S-X under the Securities Act;
amendments to rule 10b-10 [17 CFR 240.10b-10] and Schedule 14A\4\ under
the Securities Exchange Act of 1934 (``Exchange Act''); \5\ technical
changes to rule 10b-10; and technical and conforming changes to various
rules and forms under the Investment Company Act.
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\1\ 15 U.S.C. 80a. Unless otherwise noted, all references to
statutory sections are to the Investment Company Act and all
references to rules under the Investment Company Act will be to
Title 17, Part 270 of the Code of Federal Regulations [17 CFR part
270].
\2\ 17 CFR 239.15A and 274.11A.
\3\ 15 U.S.C. 77a.
\4\ 17 CFR 240.14a-101.
\5\ 15 U.S.C. 78a.
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Table of Contents
I. Introduction
II. Background
A. Mutual Fund Sales Charges
B. Adoption of Rule 12b-1
C. Developments Following Rule 12b-1's Adoption
D. The Current Role of 12b-1 Fees
E. Additional Commission Consideration of Rule 12b-1
III. Discussion
A. Summary of Our Proposals
B. Rescission of Rule 12b-1
C. Proposed Rule 12b-2: The Marketing and Service Fee
D. Proposed Amendments to Rule 6c-10: The Ongoing Sales Charge
E. Proposed Amendments to Rule 10b-10: Transaction Confirmations
F. Shareholder Approval
G. Application to Funds of Funds
H. Application to Funds Underlying Separate Accounts
I. Proposed Amendments to Rule 6c-10: Account-Level Sales Charge
J. Amendments To Improve Disclosure to Investors
K. Proposed Conforming Amendments to Rule 11a-3
L. Other Proposed Conforming Amendments
M. Potential Impact of Proposed Rule Changes
N. Transition
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IV. Paperwork Reduction Act
V. Cost-Benefit Analysis
VI. Initial Regulatory Flexibility Analysis
VII. Consideration of Burden on Competition and Promotion of
Efficiency, Competition and Capital Formation
VIII. Small Business Regulatory Enforcement Fairness Act
IX. Statutory Authority
Text of Proposed Rules and Form Amendments
I. Introduction
More than 87 million Americans, representing slightly less than
half of all households, own mutual funds.\6\ Some investors buy fund
shares directly from mutual fund sponsors without paying a sales
charge.\7\ However, most fund investors buy through intermediaries.\8\
These intermediaries include broker-dealers, banks, insurance
companies, financial planners, and retirement plans. When investors use
intermediaries to buy fund shares, they typically will pay (either
directly or indirectly) some form of sales charge or service fees to
compensate the intermediaries for the services they provide.\9\
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\6\ Investment Company Institute (``ICI''), Profile of Mutual
Fund Shareholders, 2009 (2010) (``Shareholder Profile Report'')
(http://ici.org/pdf/rpt_profile10.pdf). Mutual funds' share of
household financial assets has grown steadily from 3 percent in 1980
to 21 percent in 2009. ICI, 2010 Investment Company Fact Book at 10
(2010) (http://www.ici.org/pdf/2010_factbook.pdf) (``2010 ICI Fact
Book'').
\7\ These are referred to as ``no-load'' funds because no sales
charge or ``load'' is charged in connection with the transaction.
See infra notes 16-17 and accompanying text.
\8\ According to the ICI, 80 percent of U.S. households that own
mutual funds outside of retirement plans hold some portion of their
fund shares through financial professionals (including brokers,
financial planners, insurance agents, bank representatives, and
accountants). 2010 ICI Fact Book, supra note 6, at 85.
\9\ Although the use of the term ``intermediary'' in this
Release is not limited to registered broker-dealers, receipt of the
fees addressed in this Release may, depending on the services
provided, require the recipient to register as a broker-dealer or
rely on an exception or exemption from broker-dealer registration.
See also note 168, infra, and accompanying text.
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Investors use intermediaries for a variety of reasons. Some want
help in selecting a particular fund or building a diversified portfolio
of investments. Others like the convenience of holding a variety of
financial assets together in the same account and receiving a single
comprehensive account statement. A growing number of investors use
mutual funds as a way to fund their retirement plans, college savings
accounts, annuity or life insurance contracts, or other tax-advantaged
investment vehicles, which are often offered by an intermediary.\10\ In
some cases, investors use an intermediary (and pay sales charges) not
necessarily for the services they obtain from the intermediary, but
simply to be able to invest in shares of a particular fund that they
cannot buy directly (i.e., that are sold only through intermediaries).
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\10\ See 2010 ICI Fact Book, supra note 6, at 97, 118. According
to the ICI, U.S. retirement plan assets totaled $16 trillion in
2009. Id. The largest individual components were Individual
Retirement Accounts (``IRAs'') and employer-sponsored defined
contribution plans, holding assets of $4.2 trillion and $4.1
trillion, respectively. Mutual funds' share of the IRA market has
increased from 22 percent in 1990 to 46 percent in 2009. Id. at 98-
99. Assets in section 529 college savings plans have grown from $2.6
billion in 2000 to $111 billion in 2009. Id. at 118.
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There are over 9,000 funds available to investors, offering a
variety of investment strategies to suit different investment
needs.\11\ Investors can select among many types of intermediaries from
which they can purchase fund shares, and have choices as to how they
pay for the services of those intermediaries. They may pay a ``sales
load'' at the time they purchase shares, or a deferred sales load when
they redeem shares, or they may invest in a fund that pays ongoing
sales charges on behalf of investors from fund assets, otherwise known
as 12b-1 fees.\12\ As an alternative, they may choose to invest through
an intermediary that deducts fees directly from the investor's account
by a separate agreement (e.g., ``wrap fee programs''). Whether an
investor pays sales charges depends upon the fee structure of the fund
in which the investor chooses to invest, and how those sales charges
are paid depends upon the ``class'' of fund shares that the investor
selects.\13\
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\11\ 2010 ICI Fact Book, supra note 6, at 16. This figure
represents the total number of registered open-end funds, and
includes separate series of a fund and ETFs.
\12\ We will use the term ``12b-1 fees'' generally to describe
fees that are paid out of fund assets pursuant to a plan adopted
under rule 12b-1 (``12b-1 plan'').
\13\ See infra Section II.C.3 of this Release.
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These sales charge arrangements are disclosed in fund prospectuses,
and are governed by a combination of statutory provisions and rules
adopted by the Commission and the Financial Industry Regulatory
Authority, Inc. (``FINRA''), a self-regulatory organization for broker-
dealers.\14\ These rules have been in place for many years and, as
discussed in more detail below, we believe that they may no longer
fully reflect the current economic realities of the mutual fund
marketplace or best serve the interests of fund investors. In this
Release, we first review how these rules developed, our experience in
administering them, changes we have observed in how funds distribute
their shares, and the evolving needs of shareholders. We then propose a
new framework that would continue to allow funds to give investors
choices as to how and when to pay for sales charges, improve disclosure
designed to enhance investor understanding of those charges, limit the
cumulative sales charges each investor pays, and eliminate
uncertainties associated with current requirements while providing a
more appropriate role for fund directors. Finally, the proposal would
offer funds and their underwriters the option of offering a class of
shares that could be sold by intermediaries subject to competition in
establishing sales charge rates.
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\14\ FINRA rules do not apply directly to mutual funds, but to
registered broker-dealers that are FINRA members, including the
principal underwriters of most funds. Most funds therefore structure
their sales loads to meet FINRA rules in order for their shares to
be distributed and sold by registered broker-dealers in the United
States.
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II. Background
A. Mutual Fund Sales Charges
When the Investment Company Act was enacted in 1940, investors paid
most of the costs of selling and promoting fund shares in the form of a
sales charge or sales ``load'' deducted from the purchase price at the
time of sale by the fund's principal underwriter (typically the fund's
adviser or a close affiliate).\15\ The sales load financed brokers'
commissions, advertisements, and other sales and promotional
activities. Only a limited number of funds, called ``no-load'' funds,
marketed their shares directly to investors without the assistance of a
retail broker, and did not charge sales loads.\16\ The selling costs of
no-load funds (primarily advertising) typically were subsidized by the
funds' investment advisers out of their profits.\17\
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\15\ See SEC, Investment Trusts and Investment Companies, H.R.
Doc. No. 279, 76th Cong., 1st Sess., pt. 3, at 813, 823 (1939)
(``Investment Trust Study''). Principal underwriters typically
confine themselves to wholesale transactions and leave the public
selling to independent retail dealers under sales agreements,
although some underwriters have their own ``captive'' retail sales
organizations. See Tamar Frankel, The Regulation of Money Managers,
Sec. 27.01 (2009 supplement) (``The Regulation of Money
Managers''). See also Division of Investment Management, U.S.
Securities and Exchange Commission, Protecting Investors: A Half
Century of Investment Company Regulation 291 (1992) (``1992
Study''). Although the principal underwriter collects the sales
load, for convenience, throughout this Release, we will simply refer
to ``funds'' as imposing sales loads or determining the amount of
sales load payable.
\16\ See Investment Trust Study, supra note 15, at 817-18. Some
funds also charged low sales loads of one to two percent. Id.
\17\ See 1992 Study, supra note 15, at 292.
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In the past, fund sales charges generally were much higher than
those
[[Page 47066]]
customarily charged today and raised concerns for Congress and the
Commission.\18\ The Commission submitted a report to Congress in 1966
concluding that mutual fund sales charges should be lowered.\19\
Following this report, Congress amended the Act in 1970 to give
rulemaking authority to the National Association of Securities Dealers,
Inc. (``NASD'') (now FINRA) to prescribe limits to prevent excessive
sales loads.\20\ Under this authority, in 1975, the NASD adopted a rule
placing a ceiling of 8.5 percent on the front-end sales load that a
fund distributed by NASD members could charge.\21\ Today, few funds
impose sales loads that approach the maximum limit, in part because of
investor resistance to paying high front-end loads, but also because of
the availability of other sources of revenue to pay distribution
costs.\22\
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\18\ During the period of 1927-1935, sales loads for broker-sold
funds ranged from five to 10 percent, but by 1935 they were often as
high as nine to 10 percent. See Investment Trust Study, supra note
15, pt. 2, 216-17. See also Investment Trusts and Investment
Companies: Hearings on S. 3580 Before a Subcomm. of the Senate Comm.
on Banking and Currency, 76th Cong., 3d Sess. 799 (1940) (statement
of L.M.C. Smith, Associate Counsel, Investment Trust Study, SEC,
discussing the ``problem'' of high sales loads).
\19\ The Commission recommended that sales loads be limited to a
statutory maximum of five percent from the prevailing typical load
of 9.3 percent. See SEC, Report on the Public Policy Implications of
Investment Company Growth, H.R. REP. No. 2337, 89th Cong., 2d Sess.
at 205, 223 (``PPI Report'').
\20\ Investment Company Act Amendments of 1970, Public Law 91-
547, Sec. 12(a), 84 Stat. 1413, 1422 (1970) (codified as amended at
section 22(b) of the Act). Section 22(b) vested this rulemaking
authority in a securities association registered under section 15A
of the Exchange Act. The NASD (now FINRA) was and is the only such
registered securities association. The Commission supported the
amendment. See Investment Company Amendments Act of 1970: Hearings
on S. 34 and S. 296 Before a Subcomm. of the Senate Comm. on Banking
and Currency, 91st Cong., 1st Sess. 6-8 (1969) (statement of Hugh
Owens, SEC Commissioner).
\21\ Order Approving Proposed Rule Change by NASD, Investment
Company Act Release No. 8980 (Oct. 10, 1975) (approving predecessor
rule to NASD Conduct Rule 2830).
\22\ See The Regulation of Money Managers, supra note 15, at
Sec. 27.03; ICI, Trends in the Fees and Expenses of Mutual Funds,
2009 (Apr. 2010) (http://www.ici.org/pdf/fm-v19n2.pdf) (``Fee Trends
Report'') (noting that in 2009 the average maximum front-end load on
stock funds was 5.3 percent).
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B. Adoption of Rule 12b-1
The most significant of these alternative revenue sources came
about when the Commission adopted rule 12b-1 in 1980.\23\ As described
in more detail below, rule 12b-1 permits a fund to use fund assets to
pay broker-dealers and others for providing services that are primarily
intended to result in the sale of the fund's shares. The Commission
adopted rule 12b-1 under its authority in section 12(b) of the
Investment Company Act,\24\ which authorizes the Commission to regulate
the distribution activities of funds that act as distributors of their
own securities.\25\ Section 12(b) was designed to protect funds from
being charged excessive sales and promotional expenses.\26\ The
requirements of the rule are intended, in part, to address the
conflicts of interest between a fund and its investment adviser that
arise when a fund bears its own distribution expenses.\27\
The Commission's adoption of rule 12b-1 arose in the context of two
significant developments in the mutual fund market that occurred during
the 1970s.\28\ First, many funds experienced a prolonged period of net
redemptions (i.e., redemptions exceeded new sales), which reduced the
amount of fund assets.\29\ Fund company representatives asserted that
using fund assets to fuel the sale of fund shares could benefit fund
shareholders by increasing economies of scale and reducing fund expense
ratios.\30\ The second was the development of money market funds and
no-load fund groups, including internally managed funds, which did not
charge sales loads but required a source of revenue to support their
direct selling efforts.\31\ By offering a less expensive way for many
investors to become fund shareholders, no-load funds promised to
introduce greater price competition in the sale of mutual funds to
retail investors, which might lower sales loads for all investors.
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\23\ Bearing of Distribution Expenses by Mutual Funds,
Investment Company Act Release No. 11414 (Oct. 28, 1980) [45 FR
73898 (Nov. 7, 1980)] (``1980 Adopting Release'').
\24\ Rule 12b-1 was also adopted pursuant to section 38(a) of
the Act. Id.
\25\ Section 12(b) makes it unlawful, with certain exceptions,
for any mutual fund ``to act as a distributor'' of its own shares in
contravention of any rules the Commission adopts as ``necessary or
appropriate in the public interest or for the protection of
investors.''
\26\ See Investment Trusts and Investment Companies: Hearings on
H.R. 10065 Before a Subcomm. of the House Comm. on Interstate and
Foreign Commerce, 76th Cong., 3d Sess. 112 (1940) (``House
Hearings'') (statement of David Schenker, Chief Counsel, Investment
Trust Study, SEC) (The purpose of section 12(b) is to prevent mutual
funds from incurring ``excessive sales, promotion expenses, and so
forth.'').
\27\ When a fund pays promotional costs, the fund's investment
adviser or distributor is relieved from bearing the expense itself,
and the adviser benefits further if the fund's expenditures result
in the growth of the fund's assets and a related increase in
advisory fees (because an adviser's fees typically are based on a
percentage of fund assets). However, commentators have noted that
the benefits to existing fund shareholders from these expenditures
may be ``speculative at best.'' See Bearing of Distribution Expenses
by Mutual Funds, Investment Company Act Release No. 10252 (May 23,
1978) [43 FR 23589 (May 31, 1978)] (``Advance Notice of Proposed
Rulemaking'') at text following n. 3.
\28\ See Payment of Asset-Based Sales Loads by Registered Open-
End Management Investment Companies, Investment Company Act Release
No. 16431 (June 13, 1988) [53 FR 23258 (June 21, 1988)] (``1988
Release'') at n.14 and accompanying text.
\29\ Total redemptions exceeded new sales for six of the seven
years between 1971 and 1977. 2010 ICI Fact Book, supra note 6, at
125.
\30\ See Advance Notice of Proposed Rulemaking, supra note 27,
at n.3 and accompanying text.
\31\ See, e.g., Valuation of Debt Instruments and Computation of
Current Price per Share by Certain Open-End Investment Companies
(Money Market Funds), Investment Company Act Release No. 13380 (July
11, 1983) [48 FR 32555 (July 18, 1983)]. An investment company is
said to have internalized its management functions when most or all
of the services traditionally provided by the investment adviser or
third parties are performed at cost by salaried employees of the
fund or by subsidiaries of the fund. See 1988 Release, supra note
28, at n.8. When the Commission proposed rule 12b-1, an application
was pending from The Vanguard Group for exemptions from the Act to
permit Vanguard funds to internalize their marketing and
distribution functions and to bear distribution costs through a
wholly owned subsidiary of the funds. See In the Matter of the
Vanguard Group, et al., Opinion of the Commission, Investment
Company Act Release No. 11645 (Feb. 25, 1981). The Commission
discussed the Vanguard application in the release and asked
commenters to address other possible methods whereby funds might be
permitted to bear distribution expenses. See Advance Notice of
Proposed Rulemaking, supra note 27, at n.5. The Commission
previously had allowed other funds with internalized management
functions to pay distribution expenses out of fund assets because it
believed these arrangements would significantly reduce the conflicts
of interest that otherwise are present when fund assets are used to
pay for distributions. See 1988 Release, supra note 28, at nn.8-10
and accompanying text.
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Before the rule's adoption, the Commission generally had opposed
the use of fund assets for the purpose of financing the distribution of
mutual fund shares, noting that existing shareholders of a fund ``often
derive little or no benefit from the sale of new shares.'' \32\ After
engaging in a thorough review of the public policy and legal
implications of permitting funds to bear these types of expenses, which
included a public hearing and two requests for public comment,\33\ the
Commission ultimately decided that there may be circumstances in which
it would be appropriate for a fund to bear its own distribution
expenses.\34\
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\32\ See Bearing of Distribution Expenses by Mutual Funds:
Statutory Interpretation, Investment Company Act Release No. 9915
(Aug. 31, 1977) [42 FR 44810 (Sept. 7, 1977)] (quoting SEC, Future
Structure of the Securities Markets (Feb. 2, 1972) [37 FR 5286 (Mar.
14, 1972)]).
\33\ See Investment Company Act Release No. 9470 (Oct. 4, 1976)
[41 FR 44770 (Oct. 12, 1976)] (announcement of hearings); Advance
Notice of Proposed Rulemaking, supra note 27; Bearing of
Distribution Expenses by Mutual Funds, Investment Company Act
Release No. 10862 (Sept. 7, 1979) [44 FR 54014 (Sept. 17, 1979)]
(``1979 Proposing Release'').
\34\ The Commission noted, however, that it and its staff would
``monitor the operation of the rules closely and will be prepared to
adjust the rules in light of experience to make the restrictions on
use of fund assets for distribution either more or less strict.''
See 1980 Adopting Release, supra note 23, at section titled
``Discussion.''
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The Commission remained concerned, however, about the inherent
conflicts of interest on the part of the fund adviser.\35\ Therefore,
in crafting the conditions of the rule, we sought to minimize the role
of the adviser and its affiliates in establishing both the amount and
uses of fund assets to support distribution.\36\ As adopted, the rule
required the fund's board of directors, and in particular its
independent directors, to play a key role in deciding the level of the
fund's distribution charges and how the revenue would be spent.\37\
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\35\ See id.
\36\ See id. at section titled ``Independence of Directors.''
See also 1988 Release, supra note 28, at section titled ``The
Development and Use of `Compensation' Plans'' (``The directors'
responsibilities under the rule were designed to provide that the
directors, not advisers or underwriters, make the fundamental
decisions regarding distribution spending.'').
\37\ See 1980 Adopting Release, supra note 23, at section titled
``Independence of Directors'' (``Since rule 12b-1 does not restrict
the kinds or amounts of payments which could be made, the role of
the disinterested directors in approving such expenditures is
crucial.'').
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Rule 12b-1 requires that, before using fund assets to pay for
distribution expenses, a fund must adopt a written plan (a ``rule 12b-1
plan'') describing all material aspects of the proposed financing of
distribution,\38\ which must contain provisions similar to several of
those the Act requires for advisory contracts between the fund and its
investment adviser.\39\ The rule 12b-1 plan must be approved initially
by the fund's board of directors as a whole, and separately by the
``independent'' directors.\40\ If the plan is adopted after the sale of
fund shares to the general public, it also must be approved initially
by a vote of at least a majority of the fund's voting securities.\41\
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\38\ Rule 12b-1(b). The plan must cover indirect as well as
direct payments for distribution. See rule 12b-1(a)(2).
\39\ See 1980 Adopting Release, supra note 23, at section
titled ``Summary'' (``The procedures in the rule by which
shareholders and directors would approve a plan to use assets for
distribution are generally similar to those prescribed by statute
for approval of investment advisory contracts.''). See also sections
15(a) and 15(c) of the Act.
\40\ We generally refer to directors who are not ``interested
persons'' of the fund as ``independent directors'' or
``disinterested directors.'' The term ``interested person'' is
defined in section 2(a)(19) of the Act. However, rule 12b-1 requires
directors to meet an additional test. In order to be considered
independent for purposes of voting on a rule 12b-1 plan, directors
must also have no direct or indirect economic interest in the
operation of the plan or in any agreements related to the plan. Rule
12b-1(b)(2). In this Release, when we discuss the role of
independent directors, the applicable standard for independence
depends on the context.
\41\ Rule 12b-1(b)(1). When we originally adopted rule 12b-1 in
1980, shareholders were required to vote whenever a rule 12b-1 plan
was instituted, regardless of whether a public offering of fund
shares had occurred. See 1980 Adopting Release, supra note 23, at
section titled ``Procedural Requirements.'' However, if a rule 12b-1
plan is adopted prior to the public offering of shares, a
shareholder vote would be a mere procedural formality and approval
would be almost automatic because all shareholders voting would
typically be the fund's organizers. Any investor who purchased
shares in a public offering after the initial adoption of the plan
would be on notice that the fund charges 12b-1 fees. Therefore, in
1996 we amended the rule to permit funds to adopt a 12b-1 plan prior
to a public offering of shares without a shareholder vote. See
Technical Amendments to Rule Relating to Payments for the
Distribution of Shares by a Registered Open-End Management
Investment Company, Investment Company Release No. 22201 (Sept. 9,
1996) [61 FR 49010 (Sept. 17, 1996)].
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The rule does not restrict the amounts of the fees that may be
approved under the plan.\42\ It also does not specify all of the
activities that are ``primarily intended to result in the sale of
shares'' and therefore may be paid by a fund only according to a rule
12b-1 plan. Nor does it specifically prohibit a fund from paying for
non-distribution expenses under a rule 12b-1 plan.\43\ Instead of
limits or restrictions, the rule requires directors (including a
majority of the independent directors) to conclude, in exercising their
reasonable business judgment and in light of their fiduciary duties,
that there is a reasonable likelihood that the plan will benefit both
the fund and its shareholders.\44\ The directors have a duty to request
and evaluate as much information as is reasonably necessary for the
directors to make an informed business decision.\45\ The rule also
requires any person authorized to direct payments under the plan or any
related agreement (such as the fund's underwriter) to provide quarterly
reports to the board of directors of all amounts expended under the
plan and the purposes for which the expenditures were made.\46\ The
fund's board of directors (including a majority of the independent
directors) must decide each year whether to re-approve the plan based
on the same considerations as required initially to adopt the plan.\47\
Any material increases in the amounts paid under the plan must be
approved by the fund's board, the fund's independent directors, and the
fund's shareholders.\48\
In the 1980 Adopting Release, the Commission provided a list of
nine factors that were intended to provide guidance to directors in
considering whether the use of fund assets for distribution would
benefit the fund and its shareholders.\49\ The factors included: (i)
The need for independent counsel or experts to assist the board; (ii)
the ``problems'' or ``circumstances'' that make the plan necessary or
appropriate; (iii) the causes of such problems or circumstances; (iv)
how the plan would address the problems; (v) the merits of possible
alternatives; (vi) the interrelationships between the plan and
distributors; (vii) the possible benefits of the plan to other persons
relative to the benefits to the fund; (viii) the effect of the plan on
existing shareholders; and (ix) in deciding whether to continue a plan,
whether the plan has produced the anticipated benefits to the fund and
its shareholders.\50\
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\42\ However, as discussed in more detail in Section II.C.1 of
this Release, rules adopted by the NASD (now FINRA) prohibit broker-
dealers from selling funds that pay more than 0.25 percent (25 basis
points) per year of fund assets as ``service fees,'' and more than
0.75 percent (75 basis points) per year of fund assets as ``asset-
based sales charges,'' effectively setting the maximum 12b-1 fees at
those amounts or less. NASD Conduct Rule 2830(d)(5) and (d)(2)(E).
\43\ See 1988 Release, supra note 28, at n.129.
\44\ Rule 12b-1(e). The rule requires that the fund set forth
and preserve in the corporate minutes the factors that the directors
considered, together with the basis for the decision to use fund
assets for distribution. Rule 12b-1(d).
\45\ Rule 12b-1(d).
\46\ Rule 12b-1(b)(3)(ii).
\47\ Rule 12b-1(b)(3)(i).
\48\ Rule 12b-1(b)(4). Any other material changes to the plan
must be approved by the fund's board and the fund's independent
directors. Rule 12b-1(b)(2).
\49\ We originally included the factors in the text of the rule
when we proposed it for public comment. See 1979 Proposing Release,
supra note 33. In order to avoid the appearance of either unduly
constricting the directors' decision-making process or of creating a
mechanical checklist, we deleted the list of factors from rule 12b-1
at its adoption. Although we decided not to require the directors to
consider any particular factors, the adopting release noted that the
enumerated factors ``would normally be relevant to a determination
of whether to use fund assets for distribution.'' See 1980 Adopting
Release, supra note 23, at section titled ``Factors.''
\50\ See 1980 Adopting Release, supra note 23, at section titled
``Factors.''
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The rule was intended to allow fund boards some latitude to
exercise their reasonable business judgment to authorize the
distribution arrangements and continue them from year to year as
circumstances warranted.\51\ The annual re-approval requirement and the
factors enumerated in our adopting release reflected an expectation
that a fund would use the rule in order to address particular
distribution problems, such
[[Page 47068]]
as periods of net redemption.\52\ The rule was also designed to allow
distribution arrangements to evolve.\53\ However, the rule ultimately
resulted in distribution practices that we did not originally
anticipate, as described below.\54\
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\51\ Id. at sections titled ``Discussion'' and ``Independence of
Directors.'' See also rule 12b-1(e) (providing that funds may
implement or continue 12b-1 plans ``only if the directors who vote
to approve such implementation or continuation conclude, in the
exercise of reasonable business judgment * * * that there is a
reasonable likelihood that the plan will benefit the company and its
shareholders''); rule 12b-1(b)(3) (requiring that a 12b-1 plan
provide in substance that ``it shall continue in effect for a period
of more than one year from the date of its execution or adoption
only so long as such continuance is specifically approved at least
annually'' by the fund's board of directors as a whole, and
separately by the independent directors).
\52\ See 1980 Adopting Release, supra note 23, at section titled
``Factors.'' See also Div. of Inv. Mgmt., SEC, Report on Mutual Fund
Fees and Expenses (2000) (http://www.sec.gov/news/studies/feestudy.htm); Joel H. Goldberg and Gregory N. Bressler, Revisiting
Rule 12b-1 under the Investment Company Act, 31 Sec. & Commodities
Reg. Rev. 147, 151 (1998) (``Goldberg and Bressler'') (factors
``presuppose that the 12b-1 plan is designed to solve a particular
distribution `problem' or to respond to specific `circumstances,'
e.g., net redemptions''); Lee R. Burgunder and Karl O. Hartmann, The
Mutual Fund Industry and Rule 12b-1 Plans: An Assessment, 15 Sec.
Reg. L.J. 364 (1988) (``although the rule does not state this
directly, the historical circumstances surrounding its preparation
as well as its legislative history strongly [indicate] that the rule
is aimed at the possible problems associated with periods of
stagnant growth or net redemptions, especially for relatively small
mutual funds'').
\53\ See 1980 Adopting Release, supra note 23, at section titled
``General Requirements'' (``Recognizing that new distribution
activities may continuously evolve in the future, and in view of the
impracticability of developing an all-inclusive list, the Commission
maintains that the better approach is to define distribution
expenses in conceptual terms * * *.'').
\54\ See 1988 Release, supra note 28, at paragraph preceding
n.46 (``The use of the rule by the fund industry has resulted in
many distribution practices that could not have been anticipated
when the rule was adopted.'').
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C. Developments Following Rule 12b-1's Adoption
Initially, some funds adopted limited 12b-1 plans and used the
revenue to pay for advertising and sales materials.\55\ In time,
however, funds began to adopt 12b-1 plans with higher fees and used the
revenue to compensate fund intermediaries for sales efforts, rather
than simply defraying promotional costs.\56\ These 12b-1 plans often
were coupled with contingent deferred sales loads, or ``CDSLs,'' as
part of a ``spread load'' arrangement, and served as an alternative to
a front-end sales load.\57\
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\55\ See Goldberg and Bressler, supra note 52, at 150. The first
12b-1 plans provided for payments of 0.25 percent or less of average
annual net assets and generally were used only to reimburse advisers
and underwriters for advertising expenses and the printing and
mailing of prospectuses and sales literature. Id.
\56\ See 1992 Study, supra note 15, at 322.
\57\ See Exemptions for Certain Registered Open-End Management
Investment Companies to Impose Contingent Deferred Sales Loads,
Investment Company Act Release No. 16619 (Nov. 2, 1988) [53 FR 45275
(Nov. 9, 1988)] (``Rule 6c-10 Proposing Release'') (proposing to
permit funds to impose CDSLs, which were often used in combination
with 12b-1 plans ``as a substitute for charging investors a front-
end sales load'').
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Unlike a traditional load, which is commonly referred to as a
``front-end'' load because it is paid at the time of purchase, fund
investors pay a CDSL from their proceeds when they redeem shares.\58\
The load is ``contingent'' because the amount payable reduces over time
and usually disappears at the end of a stated period. When combined
with the payment of 12b-1 fees, a CDSL operates as a deferred payment
plan for sales charges.\59\ Instead of paying a sales load at the time
of purchase, a greater portion of the investor's money is invested in
the fund at the outset, and the investor pays sales charges over time,
albeit indirectly through charges against fund assets. An investor who
redeems early compensates the fund underwriter (which has already
advanced payments to intermediaries) by paying the CDSL in place of
uncollected revenues from 12b-1 fees attributable to the investor's
assets.
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\58\ Rule 22c-1 under the Act requires mutual funds to redeem
shares at a price based on their net asset value. In order to impose
CDSLs, funds sought and we granted exemptions from this and other
provisions to permit shareholders to defer their payment of sales
charges until redemption. See, e.g., E.F. Hutton Investment Series,
Inc., Investment Company Act Release Nos. 12079 (Dec. 4, 1981) [46
FR 60703 (Dec. 11, 1981)] (notice) and 12135 (Jan. 4, 1982) (order).
After issuing numerous exemptions, we codified them in rule 6c-10,
which permits funds complying with the rule to impose CDSLs without
first having to obtain individual exemptions. Exemption for Certain
Open-End Management Investment Companies to Impose Contingent
Deferred Sales Loads, Investment Company Act Release No. 20916 (Feb.
23, 1995) [60 FR 11890 (Mar. 1, 1995)]. We later amended the rule to
permit other types of deferred sales loads, including a form of
account-level sales charge we referred to as an ``installment
load.'' Exemption for Certain Open-End Management Investment
Companies to Impose Contingent Deferred Sales Loads, Investment
Company Act Release No. 22202 (Sept. 9, 1996) [61 FR 49011 (Sept.
17, 1996)] (``1996 Rule 6c-10 Amendments'').
\59\ See 1988 Release, supra note 28, at n.69 and accompanying
text.
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These spread load arrangements raised a number of concerns for the
Commission. First, the 12b-1 fees were higher than expected \60\ and
seemed inconsistent with one of the original arguments that fund
managers had advanced in support of rule 12b-1, which was to facilitate
the creation of economies of scale that would lower expenses for fund
shareholders.\61\ Moreover, these plans took on the appearance of more
permanent arrangements, which threatened to undermine the role of fund
directors in managing the use of fund assets for distribution because
the arrangements created multi-year business obligations on the part of
distributors. As a practical matter, the arrangements limited the
ability of fund directors to terminate the plan because ending the plan
would deny distributors their future payments.\62\
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\60\ Id. at nn.116-23 and accompanying text. See also Goldberg
and Bressler, supra note 52, at nn.22-24 and accompanying text.
\61\ See Advance Notice of Proposed Rulemaking, supra note 27,
at n.3 and accompanying text (``Commentators also argued that the
use of fund assets to finance distribution activities could lead to
increased sales of shares, thereby alleviating the difficulties
perceived to result from net redemptions or small asset size,'' such
as higher expense ratios.). The Commission's concern about the
changing uses of 12b-1 fees was later reflected in the 1988 proposal
to amend rule 12b-1. The amendments would have required annual
shareholder approval of 12b-1 plans, because ``while shareholders
may see good reason to approve a plan in the early years of a fund
to stimulate growth to a sufficient level for economies of scale to
be achieved, they may have a quite different opinion of the utility
of a 12b-1 plan once a fund has matured.'' 1988 Release, supra note
28, at text following n.187.
\62\ 1988 Release, supra note 28 at section titled ``The
Development and Use of `Reimbursement' Plans.'' See also Goldberg
and Bressler, supra note 52 (``It would be economic folly * * * for
a mutual fund underwriter continually to advance sales commissions
to selling dealers as part of a CDSL arrangement if it were not
virtually certain that the 12b-1 plan would continue in effect
indefinitely.'').
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The Commission responded to these developments by proposing
amendments to rule 12b-1 in 1988, which effectively would have
prohibited spread load arrangements.\63\ Many commenters opposed the
proposed amendments, arguing that spread load plans benefited investors
by permitting them to defer their distribution costs and avoid high
front-end loads.\64\ The Commission never adopted those amendments.
Instead, over the years, the Commission sought to address the
developing concerns raised by rule 12b-1 by other means, as discussed
below.\65\
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\63\ See 1988 Release, supra note 28, at nn.144-50 and
accompanying text. Among other things, the 1988 proposed amendments
would have required that payments under a 12b-1 plan be made on a
``current basis,'' which would have restricted the ability of a fund
to pay for distribution expenses incurred on the fund's behalf in
prior years (such as when the underwriter advances payment of the
sales load to the broker after completion of the sale). In addition,
the proposed amendments would have required payments made under a
rule 12b-1 plan to be tied to specific distribution services
actually provided to the fund and its shareholders. See also 1992
Study, supra note 15, at 323.
\64\ See, e.g., Comment Letter of the ICI at 9-12 (Sept. 19,
1988) (File No. S7-10-88).
\65\ Another concern relates to the recent growth in the
frequency and amount of payments made by fund advisers to broker-
dealers and others distributing fund shares, a practice commonly
known as ``revenue sharing.'' Because fund advisers derive their
earnings from sources including advisory fees paid by the fund, the
payment of distribution expenses by advisers could involve the
indirect use of fund assets to pay for distribution. Rule 12b-1
explicitly applies to direct and indirect financing of distribution
activities. Thus, revenue sharing payments could be construed as an
indirect use of fund assets for distribution that is unlawful unless
made pursuant to a rule 12b-1 plan. See supra note 38. The
Commission has historically taken the position that an adviser's
financing of distribution activities would not necessarily involve
an indirect use of fund assets if the payments are made from profits
that are ``legitimate'' or ``not excessive,'' i.e., profits that are
``derived from an advisory contract which does not result in a
breach of fiduciary duty under section 36 of the Act.'' See 1980
Adopting Release, supra note 23, at section titled ``General
Requirements.'' In contrast, for example, an indirect use of fund
assets may result if advisory fees were increased in contemplation
of distribution payments by the adviser. We are not addressing
revenue sharing practices in connection with these proposals.
However, we remain concerned that revenue sharing payments may give
broker-dealers and other recipients incentives to market particular
funds or fund classes, through ``preferred lists'' or otherwise, and
that such incentives create conflicts of interest (e.g., between a
broker-dealer's suitability obligation to its customers and its
self-interest in maximizing revenue) that may be inadequately
disclosed. We proposed new requirements regarding disclosure of
revenue sharing payments in 2004 in connection with our ``Point of
Sale'' proposals. See Confirmation Requirements and Point of Sale
Requirements for Transactions in Certain Mutual Funds and Other
Securities, and Other Confirmation Requirement Amendments, and
Amendments to the Registration Form for Mutual Funds, Investment
Company Act Release No. 26341 (Jan. 24, 2004) [69 FR 6438 (Feb. 10,
2004)]. See also Point of Sale Disclosure Requirements and
Confirmation Requirements for Transactions in Mutual Funds, College
Savings Plans, and Certain Other Securities, and Amendments to the
Registration Form for Mutual Funds, Investment Company Act Release
No. 26778 (Feb. 28, 2005) [70 FR 10521 (Mar. 4, 2005)] (reopening of
comment period and supplemental request for comment). We are
continuing to consider further rule amendments related to revenue
sharing.
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[[Page 47069]]
1. Imposition of Sales Load Caps
In 1992, the Commission approved amendments to NASD Conduct Rule
2830 (the ``NASD sales charge rule''), which had the effect of limiting
the maximum amount of 12b-1 fees that many funds could deduct from fund
assets pursuant to a rule 12b-1 plan, based roughly on the then-
existing NASD limits on sales loads.\66\ While it does not directly
regulate what funds can charge, the NASD (now FINRA) sales charge rule
bars registered broker-dealers who are members from selling funds that
impose combined sales charges that exceed certain limits. The limits
vary based on whether the fund has a 12b-1 fee, a ``service fee,'' \67\
rights of accumulation,\68\ and other features.
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\66\ NASD Conduct Rule 2830(d). The NASD sales charge rule is
currently administered by FINRA. FINRA derives its authority to
regulate the level of mutual fund sales charges from section
22(b)(1) of the Act. See supra note 20. See Order Approving Proposed
Rule Change Relating to the Limitation of Asset-Based Sales Charges
as Imposed by Investment Companies, Exchange Act Release No. 30897
(July 7, 1992) [57 FR 30985 (July 13, 1992)] (``1992 NASD Rule
Release''). In 2009, FINRA proposed to re-codify the rule, in
conjunction with its consolidation of rules issued by the NASD and
by the New York Stock Exchange, and to revise the rule with regard
to the disclosure of cash compensation. See FINRA, Investment
Company Securities: FINRA Requests Comment on Proposed Consolidated
FINRA Rule Governing Investment Company Securities, Regulatory
Notice 09-34 (June 2009).
\67\ See infra note 152 and accompanying text for additional
information on service fees.
\68\ Rights of accumulation allow investors to qualify for a
reduced sales charge (or ``breakpoint'') based on the aggregate
value of shares previously purchased or owned plus the securities
being purchased. NASD Conduct Rule 2830(b)(7).
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Prior to 1992, the NASD sales charge rule had not been applied to
rule 12b-1 fees that funds deducted from assets as a substitute for a
front-end sales load. In 1992, the NASD determined that it was
appropriate to amend the rule specifically to encompass all forms of
mutual fund sales compensation, including these ``asset-based sales
charges.'' \69\
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\69\ The NASD explained that the changes were necessary to: (i)
Assure a level playing field among all members selling mutual fund
shares; and (ii) prevent the circumvention of its sales charge caps
through the use of rule 12b-1 plans, because it had become possible
for funds to use 12b-1 plans to charge investors more for
distribution than could have been charged as a front-end sales load
under the existing sales charge rule. See NASD Notice to Members 92-
41; 1992 NASD Rule Release, supra note 66. In its comment letter,
the ICI agreed that the proposed expansion of the NASD rule to
include asset-based sales charges ``appropriately recognizes that
Rule 12b-1 fees * * * alone or in combination with [CDSLs],
generally serve as the functional equivalent of traditional front-
end sales loads.'' Comment Letter of the ICI (May 10, 1991) (File
No. SR-NASD-90-69).
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As amended, the rule caps the annual amount of asset-based sales
charges that a fund may deduct at 75 basis points.\70\ In addition, a
fund with an asset-based sales charge is subject to an aggregate cap of
6.25 percent of new gross sales (rising to 7.25 percent of new gross
sales if the fund does not pay a service fee), plus interest, on the
total sales charges levied (e.g., asset-based, front-end, and
deferred).\71\ This aggregate cap requires a fund with an asset-based
sales charge to keep a running balance from which all sales charges
imposed by the fund are deducted.\72\ Because it is calculated at the
fund level based on the amount of aggregate new fund shares sold, the
aggregate cap does not limit the actual amount of sales charges that a
particular investor may pay.\73\ Thus, it is possible for a long-term
shareholder in a fund with an asset-based sales charge to pay more in
total sales charges than would have been the case if that investor had
paid a traditional front-end load.\74\
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\70\ NASD Conduct Rule 2830(d)(2)(E)(i).
\71\ New gross sales excludes sales from the reinvestment of
distributions and exchanges of shares between investment companies
in a single complex, between classes of an investment company with
multiple classes of shares, or between series of a series investment
company. NASD Conduct Rule 2830(d)(2)(A) and (B).
\72\ In effect, so long as a fund with asset-based sales charges
continues to have new sales, it may never exceed the aggregate cap.
\73\ For convenience, in this Release we refer to the aggregate
cap as a fund-level cap, but FINRA members may treat each class of
shares and each series of a fund as a separate investment company
for purposes of the sales charge rule and these calculations. See
NASD Notice to Members 93-12 at n.1 (1993) (``NASD Sales Charge Rule
Q&A'').
\74\ In our statement on the proposed rule change, we
acknowledged this possibility. See 1992 NASD Rule Release, supra
note 66, at discussion following n.16 (``Because the proposed rule
change contemplates a minimum standard of fund-level accounting
rather than individual shareholder accounting, it is possible that
long-term shareholders in a mutual fund that has an asset-based
sales charge may pay more in total sales [charges] than they would
have paid if the mutual fund did not have an asset-based sales
charge.''). However, we also noted that individual shareholder
accounting would be permitted under the rule amendment, and
encouraged its use. See Notice of Proposed Rule Change by National
Association of Securities Dealers, Inc. Relating to the Limitation
of Asset-Based Sales Charges as Imposed by Investment Companies,
Exchange Act Release No. 29070 (April 12, 1991) [56 FR 16137 (Apr.
19, 1991)] (``NASD Notice of Proposed Rule Change'') at section
titled ``Method of Calculating the Total Sales Charges'' (``It is
the NASD's intention that fund-level accounting be required at a
minimum, thereby not precluding the use of more protective methods.
A fund, based upon its particular circumstances and economic
perspective, may choose the option of individual shareholder
accounting.'').
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As amended, the NASD rule also places a cap of 25 basis points on
the amount of a service fee that a fund may deduct annually from fund
assets in order to pay intermediaries for providing follow-up
information and account services to clients over the course of their
investment in the fund.\75\ Unlike the asset-based sales charge, the
service fee is not limited by an aggregate cap and, as a result, is
almost always paid for an indefinite period (i.e., for as long as the
investor holds the shares).\76\
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\75\ NASD Conduct Rule 2830(d)(5).
\76\ See 1992 NASD Rule Release, supra note 66, at section
III.A.
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2. Enhanced Disclosure
Over the years, the Commission has taken several steps designed to
improve investor understanding of 12b-1 fees and the impact they have
on fund expenses and investor returns. We required funds to include a
fee table in the prospectus identifying, among other things, the amount
of any 12b-1 fee paid.\77\ As part of the 1992 amendments to the NASD
sales charge rule, we also approved a new provision prohibiting
registered broker-dealers from describing funds as ``no-load'' funds if
the funds charged 12b-1 fees greater than 25 basis points.\78\ We
amended our proxy rules to require funds to better describe material
facts to shareholders when requesting approval of a rule 12b-1 plan or
an amendment to the plan.\79\
[[Page 47070]]
Through our Web site, we have also provided investors with information
and tools designed to enhance their understanding of the fees and
distribution expenses they pay as a consequence of owning mutual
funds.\80\
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\77\ See Consolidated Disclosure of Mutual Fund Expenses,
Investment Company Act Release No. 16244 (Feb. 1, 1988) [53 FR 3192
(Feb. 8, 1988)].
\78\ See 1992 NASD Rule Release, supra note 66. See also NASD
Conduct Rule 2830(d)(4).
\79\ Amendments to Proxy Rules for Registered Investment
Companies, Investment Company Act Release No. 20614 (Oct. 13, 1994)
[59 FR 52689 (Oct. 19, 1994)].
\80\ See Mutual Fund Cost Calculator (http://www.sec.gov/investor/tools/mfcc/mfcc-intsec.htm).
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3. Multiple Classes
We also permitted funds to offer multiple ``classes'' of shares,
each with its own arrangement for the payment of distribution costs and
related shareholder services.\81\ These multiple class arrangements
were designed to give investors a choice of ways to pay for sales
charges.\82\ Investors in one class of shares have the same investment
experience as investors in the other classes, except for expenses
related to distribution and shareholder services. These multiple class
arrangements have been adopted by most fund groups that sell through
intermediaries.\83\
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\81\ See Exemption for Open-End Management Investment Companies
Issuing Multiple Classes of Shares; Disclosure by Multiple Class and
Master-Feeder Funds; Class Voting on Distribution Plans, Investment
Company Act Release No. 20915 (Feb. 23, 1995) [60 FR 11876 (Mar. 2,
1995)] (adopting rule 18f-3). Rule 18f-3 contains requirements that
protect the rights and obligations of each class as against all
other classes, particularly with regard to shareholder voting
rights, and prescribes methods for allocating income, expenses,
realized gains and losses, and unrealized appreciation and
depreciation among classes in a multi-class fund.
\82\ See Exemption for Open-End Management Investment Companies
Issuing Multiple Classes of Shares; Disclosure by Multiple Class and
Master-Feeder Funds, Investment Company Act Release No. 19955, at
section titled ``Background'' (Dec. 15, 1993) [58 FR 68074 (Dec. 23,
1993)] (stating that some funds use different classes ``to offer
investors a choice of methods for paying for the costs of selling
fund shares''). See also Z. Jay. Wang, Vikram K. Nanda & Lu Zheng,
The ABCs of Mutual Funds: On the Introduction of Multiple Share
Classes, EFA 2005 Moscow Meetings Paper (Feb. 2005) (http://ssrn.com/abstract=676246); Vance P. Lesseig, D. Michael Long &
Thomas I. Smythe, Gains to Mutual Fund Sponsors Offering Multiple
Share Class Funds, 25 J. Fin. Res. 81 (2002).
\83\ See ICI, Mutual Fund Distribution Channels and Distribution
Costs (July 2, 2003) (http://www.ici.org/pdf/per09-03.pdf).
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Class designations are not standardized by law, although funds
often use similar nomenclature.\84\ Class ``A'' shares generally are
sold with a front-end sales load, and also often have a 12b-1 fee of
about 25 basis points.\85\ Class ``B'' shares typically are sold
without a front-end load but charge a spread load consisting of a 12b-1
fee of 100 basis points (the maximum rate under NASD Conduct Rule 2830,
including a service fee) and a declining CDSL. Class B shares usually
convert automatically to class A shares after a fixed period of time
has elapsed (commonly six to eight years from the date of
purchase).\86\ Class ``C'' shares typically charge a ``level load''
consisting of a 100 basis point 12b-1 fee that is imposed for as long
as the investor owns the shares, and also may charge a small CDSL of
one percent if a shareholder redeems within the first year, but seldom
convert to class A shares with lower 12b-1 fees.\87\ Other classes may
be available only to certain types of investors, such as those who
invest in retirement plans, are institutional investors, or purchase
through a particular intermediary or type of intermediary, such as a
financial planner.\88\
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\84\ The Commission staff has prepared information on mutual
fund share classes, available on the Commission's Web site. SEC,
Mutual Fund Classes (http://www.sec.gov/answers/mfclass.htm). While
there are many variations, for convenience, throughout this Release
we use the terms ``A shares,'' ``B shares,'' and ``C shares'' to
refer to the typical share class structures, as described in the
text above.
\85\ Class A shares may also be sold with the load waived. See
infra note 93 and accompanying text.
\86\ See 2010 ICI Fact Book, supra note 6, at 74. While there is
no legal requirement for conversion, funds typically provide it. The
conversion feature reflects the underlying economics of class B
shares. When the underwriter recoups the commission it has advanced
to the selling broker, the shareholder is considered to have paid
his share of distribution costs. (If the underwriter has advanced a
commission to the intermediary, it would retain 75 basis points of
the 100 basis points it collects in 12b-1 fees and forward only the
25 basis points to the intermediary.)
\87\ See supra note 84.
\88\ Id.
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D. The Current Role of 12b-1 Fees
Rule 12b-1 plans continue to play a significant role in paying for
fund distribution costs. The majority of funds have adopted rule 12b-1
plans, which paid a total of $9.5 billion in 12b-1 fees in 2009 (down
from a high of $13.3 billion in 12b-1 fees in 2007).\89\
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\89\ See 2010 ICI Fact Book, supra note 6, at 75. This figure
excludes 12b-1 fees deducted from assets of funds underlying
insurance company separate accounts offering variable annuities and
mutual funds that invest primarily in other mutual funds. See also
Comment Letter of the ICI at Appendix I (July 19, 2007) (File No. 4-
538). Unless otherwise noted, references to comment letters in this
Release are to letters submitted in response to the Commission's
request for comments in connection with a 2007 Commission roundtable
on rule 12b-1. See SEC Press Release, Commission Announces
Roundtable Discussion Regarding Rule 12b-1 (May 29, 2007) (http://www.sec.gov/news/press/2007/2007-106.htm). These comment letters are
available in File No. 4-538 (http://www.sec.gov/comments/4-538/4-538.shtml).
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There has been a trend in fund class share ownership away from
those that impose the highest sales loads and 12b-1 fees. In recent
years, no-load share classes have attracted more net new cash flow than
load share classes.\90\ According to Investment Company Institute
(``ICI'') figures, in 2009, $323 billion flowed into no-load share
classes of long-term mutual funds, while in comparison, load share
classes only received $39 billion in net new cash flow.\91\ In 2009,
class B shares experienced net outflow for a seventh consecutive year,
with total net outflow of approximately $24 billion.\92\ In contrast,
net new investment in class A shares was approximately $19 billion, and
net new investment in class C shares was approximately $37 billion.\93\
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\90\ See 2010 ICI Fact Book, supra note 6, at 76.
\91\ Id. at 76.
\92\ Id. at 76. Net outflow from B share classes can result from
purchases being exceeded by: (i) Redemptions; and (ii) shares
converting to another class after a certain period of time. As a
result of their (typically) automatic conversion feature, B shares
generally are self-limiting as a class unless they continue to be
sold at the same rate as they were sold previously.
\93\ Id. at 76. Many class A shares today are sold with the load
waived or substantially reduced. For example, many funds permit
broker-dealers to sell their shares with the front-end load waived
or substantially reduced, for use in wrap fee programs. In wrap fee
programs, instead of paying a one-time sales charge for each
investment purchase, a customer pays the broker an annual percentage
of the assets held through that broker in exchange for the ability
to buy and redeem securities without additional sales charges.
According to one study, in 2008, 60 percent of class A shares were
sold at NAV with the load waived. Strategic Insight Mutual Fund
Research and Consulting, LLC, Perspectives on Intermediary Sales:
Trends in Fund Sales by Distribution Channel and Share Class (May
2009). The ICI found that, although the average maximum front-end
sales load on stock funds in 2009 was 5.3 percent, the average sales
load actually paid by investors was only 1.0 percent, due to the
impact of load-waived class A shares. See 2010 ICI Fact Book, supra
note 6, at 65.
---------------------------------------------------------------------------
Although more investors appear to be investing in no-load funds and
share classes, these statistics do not reflect a trend away from using
intermediaries.\94\ According to the ICI, 80 percent of investors who
own funds outside of a retirement plan use an intermediary that
provides professional financial assistance (``financial advisor'').\95\
Of those investors, almost half own funds purchased solely through
financial advisors, while the rest own funds purchased through
financial advisors as well as directly from fund companies, mutual fund
supermarkets, or discount brokers.\96\ The data suggest a growing
[[Page 47071]]
predominance of no-load or load-waived classes in funds that
traditionally were sold with a load.\97\ In these circumstances,
investors do not pay a sales load, but pay distribution expenses
through a separate fee arranged between the intermediary and the
investor, and/or through the payment of ongoing ``service fees.'' \98\
---------------------------------------------------------------------------
\94\ Among households owning mutual funds, only 20 percent of
these investors purchased directly from mutual funds in 2009. See
Shareholder Profile Report, supra note 6, at 27. The prevalence of
mutual fund ``supermarkets'' (described in note 96, infra),
employer-sponsored retirement plans, and fee-based financial
advisers (advisers who charge investors separately for their
services rather than through a load or fee assessed at the fund
level) has provided investors alternative means of purchasing no-
load funds. See 2010 ICI Fact Book, supra note 6, at 65. Many
investors now purchase no-load funds through these intermediaries.
\95\ See 2010 ICI Fact Book, supra note 6, at 85.
\96\ Id. at 85. Mutual fund supermarkets, which are sponsored by
brokerage firms, ``permit investors to purchase and hold a broad
range of funds from many different fund sponsors through a single
brokerage account.'' Robert C. Pozen, The Mutual Fund Business (2d
Ed., 2002), at 304. The primary benefit of this ``one-stop shopping
venue'' is simplicity: An investor can buy funds from different fund
families and receive all of their statements in a single report.
Discount brokers allow investors to trade securities at a lower
commission rate but provide less individualized service.
\97\ See 2010 ICI Fact Book, supra note 6, at 76.
\98\ See generally Carol Gehl, et al., Mutual Fund Regulation
Sec. 18:6.1 (May 2008); Fee Trends Report, supra note 22, at 6
(noting that although in the 1980s and 1990s sales loads were a
primary means of compensating brokers for services provided to
investors, in recent years brokers have increasingly been
compensated through ``asset-based'' fees).
---------------------------------------------------------------------------
A significant use of 12b-1 fees today is for what is typically
characterized as ``services'' provided to investors after the sale by
the broker-dealers and other intermediaries who sell the fund.
According to the Investment Company Institute, more than half of all
12b-1 fees paid by funds are used for this purpose,\99\ with broker-
dealers and bank trust departments being the primary recipients. Under
the NASD sales charge rule discussed above, up to 25 basis points of
fund assets annually may be paid to members as a ``service fee.'' \100\
---------------------------------------------------------------------------
\99\ See 2010 ICI Fact Book, supra note 6, at 73.
\100\ NASD Conduct Rule 2830(d)(5). The NASD rule defines
``service fees'' as ``payments by [a fund] for personal service and/
or the maintenance of shareholder accounts.'' NASD Conduct Rule
2830(b)(9). These services could include responding to customer
inquiries, providing information on investments, and reviewing
customer holdings on a regular basis, but would not include sub-
transfer agency services, sub-accounting services, or administrative
services. See NASD Sales Charge Rule Q&A, supra note 73, at Question
17. The NASD rule does not address whether ``service fees''
are required to be included in 12b-1 plans. Id. at Question
25. However, we understand that funds continue to include
``service fees'' as distribution expenses under rule 12b-1,
presumably because the stream of payments (often called ``trail
commissions'') may act as an inducement to intermediaries' sales
personnel to sell fund shares and, arguably, because fund
intermediaries would provide these services in the ordinary course
of business regardless of whether they receive compensation from the
fund (which may be just one of many other investments held by the
intermediary's clients).
---------------------------------------------------------------------------
Amounts deducted from assets in excess of a service fee are
typically charged to support the fund's distribution efforts and
operate as an alternative to a front-end sales load.\101\ These 12b-1
fees, which are used to pay the selling costs of B and C share classes,
are ``asset-based sales charges'' under the NASD sales charge caps and
are limited to a maximum of 75 basis points of fund assets, annually,
as discussed above.
---------------------------------------------------------------------------
\101\ According to the ICI, approximately 40 percent of 12b-1
fees are used for this purpose. See 2010 ICI Fact Book, supra note
6, at 73.
---------------------------------------------------------------------------
A common use of 12b-1 fees is to pay for the fund to be included on
third-party platforms for purchasing mutual funds, such as employer-
sponsored retirement plans and fund supermarkets. Supermarkets and
retirement plans have become major avenues by which investors purchase
mutual funds. They have assumed many of the recordkeeping and ongoing
servicing and support functions for shareholders that funds otherwise
would perform, and these are often paid for, at least partially,
through 12b-1 fees.\102\ Under the NASD sales charge rule, no-load
funds are able to compensate discount brokers and supermarkets for the
costs of servicing shareholders in those channels through asset-based
fees of up to 25 basis points annually of the value of fund shares that
are held in the intermediary's client accounts.\103\ Funds that are
offered as investment options in defined contribution retirement plans
also may pay 12b-1 fees (often 50 basis points or more annually) to the
plan administrator to offset some of the costs of servicing
shareholders (and perhaps other participants) who invest through those
plans.\104\
---------------------------------------------------------------------------
\102\ See infra note 153. A representative of a large fund
supermarket commented at our roundtable on rule 12b-1 that some fund
advisers also pay supermarket fees through revenue sharing
arrangements. See Roundtable Transcript, infra note 109, at 84-87
(John Morris, Charles Schwab & Co.). See also supra note 65; infra
paragraph following note 286 (requesting comment whether investors
in omnibus accounts receive equivalent levels of service relative to
investors in retail accounts with similar 12b-1 fees).
\103\ See NASD Conduct Rule 2830(d)(4). Discount brokers and
fund supermarkets typically hold one account with the fund in the
name of the broker, and then provide sub-accounting for individual
shareholder holdings of fund shares. See Mutual Fund Redemption
Fees, Investment Company Act Release No. 26782 (Mar. 11, 2005) [70
FR 13328 (Mar. 18, 2005)] at text following n.10 (``Rule 22c-2
Adopting Release'').
\104\ See Comment Letter of Charles P. Nelson (June 19, 2007).
Employers sponsoring defined contribution plans typically hire
third-party administrators to advise them in selecting the
investment options offered to employees, perform recordkeeping and
administrative functions (e.g., producing account statements and
recording transactions), provide educational materials and seminars,
and maintain call centers and Internet Web sites for use by plan
participants. See ICI, Mutual Fund Distribution Channels and
Distribution Costs, supra note 83.
---------------------------------------------------------------------------
A minor use of 12b-1 fees is to pay expenses of the fund's
principal underwriter and for advertising and promotions. Although this
was one of the main purposes for which 12b-1 plans originally were
intended, in recent years, only about two percent of 12b-1 fees have
been used to pay these types of expenses.\105\
---------------------------------------------------------------------------
\105\ See 2010 ICI Fact Book, supra note 6, at 73.
---------------------------------------------------------------------------
E. Additional Commission Consideration of Rule 12b-1
In 2004, the Commission amended rule 12b-1 to prohibit fund
advisers from directing fund brokerage to compensate broker-dealers for
selling fund shares.\106\ When we proposed those amendments, we invited
comment on whether the Commission should consider additional changes to
the rule, including potentially rescinding it.\107\ We made this
request after observing that the current practice of using 12b-1 fees
as a substitute for a sales load was a departure from the rule as
envisioned in 1980.\108\
---------------------------------------------------------------------------
\106\ Prohibition on the Use of Brokerage Commissions to Finance
Distribution, Investment Company Act Release No. 26591 (Sept. 2,
2004) [69 FR 54728 (Sept. 9, 2004)] (``2004 Rule 12b-1 Amendments
Adopting Release''). Although fund advisers may choose which brokers
will execute the fund's transactions when buying and selling
portfolio securities, fund brokerage is an asset of the fund. We
prohibited the practice of using brokerage to reward sales of fund
shares because it produces powerful incentives for advisers, is
potentially harmful to fund investors, and ``reliance on fund
directors to police the use of fund brokerage to promote the sale of
fund sales is not sufficient.'' Id. at text following n.16.
\107\ See Prohibition on the Use of Brokerage Commissions to
Finance Distribution, Investment Company Act Release No. 26356 at
section IV (Feb. 24, 2004) [69 FR 9726 (Mar. 1, 2004)] (``2004 Rule
12b-1 Amendments Proposing Release''). Comments are available in
File No. S7-09-04, at http://www.sec.gov/rules/proposed/s70904.shtml.
\108\ Id. See also John A. Haslem, Investor Learning and Mutual
Fund Advertising and Distribution Fees, J. Investing 53 (Winter
2009) (``Haslem'') (noting ``the transformation of 12b-1 fees from
their original primary use for advertising and promotion'' and
concluding that ``Rule 12b-1 fees are now used primarily to reward
brokers for sales of adviser mutual fund shares'').
---------------------------------------------------------------------------
To further explore the available options for reforming the rule, we
held a roundtable on rule 12b-1 on June 19, 2007, to solicit the views
of investor advocates, fund industry representatives, independent
directors, current and former regulators, representatives from broker-
dealers and other intermediaries who sell fund shares, and interested
observers.\109\ The participants responded to Commissioners' questions
regarding the costs and benefits of 12b-1 plans, the role of 12b-1
plans in current fund distribution practices, and options for reform.
The roundtable discussions and the nearly 1,500 comment letters we
[[Page 47072]]
received on the topic greatly informed our understanding of the
operation of rule 12b-1 and the role it plays in the distribution of
mutual funds today.
---------------------------------------------------------------------------
\109\ See http://www.sec.gov/spotlight/rule12b-1.htm (which
provides links to various materials relating to the rule 12b-1
roundtable). An unofficial transcript of the June 19, 2007 Rule 12b-
1 Roundtable is available at http://www.sec.gov/news/openmeetings/2007/12b1transcript-061907.pdf (``Roundtable Transcript'').
---------------------------------------------------------------------------
Many of the panelists and commenters representing fund management
companies and intermediaries contended that the rule had benefited both
funds and investors in substantial ways, and that the central problem
lay with the rule's outdated requirements.\110\ Some of these
commenters asserted that rule 12b-1 provides a cost-efficient way of
paying for services that investors want and need (i.e., by
``mutualizing'' them), including ongoing services from financial
professionals and access to funds through fund supermarkets and
retirement platforms.\111\ Several participants thought that investors
preferred paying rule 12b-1 fees to paying front-end loads, and equated
a decision to invest in a class of shares with a 12b-1 fee with a
decision to pay a sales load over time.\112\ They asserted that rule
12b-1 fees were, at least in part, responsible for bringing down the
overall cost of investing in funds.\113\
---------------------------------------------------------------------------
\110\ See, e.g., Roundtable Transcript, supra note 109, at 172
(Michael Sharp, Citi Global Wealth Management); Comment Letter of
the Independent Directors Council (July 19, 2007) (``IDC supports
retaining the framework of Rule 12b-1 and believes that changes to
the rule should take the form of enhancements and clarifications to
adapt the rule to the modern world of fund distribution.'').
\111\ See, e.g., Roundtable Transcript, supra note 109, at 111-
113 (Paul Haaga, Capital Research Management).
\112\ See, e.g., id. at 64 (Martin Byrne, Merrill Lynch).
\113\ See, e.g., id. at 171 (Michael Sharp, Citi Global Wealth
Management).
---------------------------------------------------------------------------
Many of these panelists emphasized the importance of 12b-1 fees to
pay for services that matter to investors.\114\ They noted that
platforms such as supermarkets and retirement plans use 12b-1 fees to
support their service infrastructures, including interactive Web sites,
investment allocation tools, and other educational materials that are
currently made available to, and benefit, fund investors in those
channels.\115\ Several roundtable participants and commenters also
noted that 12b-1 fees paid to platforms have enabled small funds and
no-load funds to compete successfully for a broader segment of the
investing population in many distribution channels, which is critical
to their distribution strategies.\116\ This development, they
contended, has been beneficial because it increases competition and
helps spur innovation.\117\
---------------------------------------------------------------------------
\114\ See, e.g., id. at 118-19 (Joseph Russo, Advantage
Financial Group); id. at 180 (Barbara Roper, Consumer Federation of
America). Commenters also emphasized the importance of 12b-1 fees
for investor servicing. See, e.g., Comment Letter of the National
Association of Insurance and Financial Advisors (July 13, 2007);
Comment Letter of the ICI (July 19, 2007).
\115\ See, e.g., Roundtable Transcript, supra note 109, at 218
(Don Phillips, Morningstar).
\116\ See, e.g., id. at 67 (Mellody Hobson, Ariel Capital
Management) (``We could not exist without the 12b-1 fee to grow the
funds.'').
\117\ See, e.g., Comment Letter of the ICI (July 19, 2007);
Comment Letter of the Securities Industry and Financial Markets
Association (July 19, 2007).
---------------------------------------------------------------------------
Other panelists were not as sanguine about rule 12b-1. They argued
that even though 12b-1 fees may pay for worthwhile services to
investors, the costs of those services are obscured in the fund's
expense ratio in a way that makes the costs less transparent and the
services less likely to be priced competitively.\118\ They questioned
the necessity of having these types of distribution charges embedded as
a fund expense. In addition, they questioned whether investors are
aware of and making informed choices about the services they pay for
through the 12b-1 fee, which many panelists agreed lacks the prominence
of a front-end load.\119\ Most commenters believed that better
disclosure and more effective communication of 12b-1 fees, and the
manner in which they are used, would be useful to investors.\120\
---------------------------------------------------------------------------
\118\ See, e.g., Roundtable Transcript, supra note 109, at 181
(Barbara Roper, Consumer Federation of America) and 185 (Richard
Phillips, K&L Gates). See also Comment Letter of Bridgeway Funds,
Inc. and Bridgeway Capital Management, Inc. (July 19, 2007); Comment
Letter of Andrew Reyburn (July 20, 2007).
\119\ See, e.g., Roundtable Transcript, supra note 109, at 121
(Brad Barber, Univ. of Cal., Davis) (``And I think what you hear
from the industry--and the message I hear over and over again--is
that investors do not like front-end loads. There is a simple
psychological reason for that. It's an in-your-face fee. When you
pay a load fee, it comes immediately out and off the top. Whereas,
if you pay a spread fee over time, it's less obvious and less
salient.''). See also Comment Letter of Michael R. Clancy (June 13,
2007) (``Very few if any clients actually understand the [12b-1]
fee, or even know that they are paying it. Of the few who actually
understand a front-end load, the overwhelming majority of those
clients don't know that there is an ongoing fee as well.'').
\120\ See, e.g., Comment Letter of National Association of
Personal Financial Advisors (July 17, 2007); Comment Letter of
Donald H. Pratt (July 19, 2007); Comment Letter of the ICI (July 19,
2007).
---------------------------------------------------------------------------
One panelist argued that 12b-1 fees have the effect of increasing
expense ratios and decreasing investment returns for investors.\121\
Some suggested that the Commission encourage (or require) that fees to
compensate distributors be paid by investors as an account charge
(through ``demutualization'' or ``externalization'').\122\ They argued
that externalizing these ``bundled costs'' would make them more visible
to shareholders and that unbundling costs and services promotes more
efficient pricing of those services.\123\ Representatives of fund
management companies and others countered that such a fee structure
already exists in the form of a mutual fund ``wrap'' account and other
types of fee-based service arrangements that charge fees comparable to
the maximum 100 basis point 12b-1 fee. They argued that it is more
cost-effective and tax-efficient for funds to collect 12b-1 fees and
credit the intermediaries, than it is for the intermediaries to charge
their clients directly through wrap accounts.\124\ As discussed above,
although more investors today invest in no-load funds and share
classes, this trend does not reflect the decreasing use of
intermediaries, but rather the growing use of wrap accounts and other
arrangements between intermediaries and investors that entail separate
fees.\125\
---------------------------------------------------------------------------
\121\ See Roundtable Transcript, supra note 109, at 119-120
(Shannon Zimmerman, Motley Fool).
\122\ See, e.g., id. at 103 (Thomas Selman, FINRA). See also
Comment Letter of Michael R. Clancy (June 13, 2007); Comment Letter
of Neil J. McCarthy, Jr. (June 19, 2007); Comment Letter of Michael
Murray (June 21, 2007).
\123\ See, e.g., Roundtable Transcript, supra note 109, at 132
(Shannon Zimmerman, Motley Fool); 204-07 (Richard M. Phillips, K&L
Gates). See also Comment Letter of Bridgeway Funds, Inc. and
Bridgeway Capital Management, Inc. (July 19, 2007) (``Mutualization
of [12b-1] fees inhibits an investor from having the necessary
information on price vs. value to make economic choices across
service providers. This distorts fundamental, free-market economics
and restricts valuable competition in the intermediary channel.'').
\124\ See, e.g., Roundtable Transcript, supra note 109, at 170-
72 (Michael Sharp, Citi Global Wealth Management). See also Comment
Letter of the ICI (July 19, 2007) (``There are significant tax and
operational disadvantages to imposing 12b-1 fees at the account-
level that likely would outweigh the benefits of this approach.'').
\125\ See supra text accompanying notes 97 and 98.
---------------------------------------------------------------------------
Several participants suggested that the term ``12b-1 fee'' causes
confusion because it encompasses so many different activities.\126\
Most roundtable participants agreed that greater transparency and
better communication of what 12b-1 fees are and how they are used are
vital to enabling investors to make optimal choices among the
alternatives offered to them.\127\ Some panelists were troubled that,
according to academic studies, many investors do
[[Page 47073]]
not appear to have a strong understanding of fund fees and expenses or
their impact on investment returns. In particular, some participants
were concerned that, because 12b-1 fees are paid automatically in small
increments over time, they are much less obvious to investors than
front-end sales loads.\128\ Unlike traditional loads, 12b-1 fees are
deducted from fund assets, and are reflected in lower investment
returns, rather than deducted directly from shareholder accounts.\129\
As a result, they may not be fully appreciated as a sales charge.\130\
In addition, the expanding number of share classes and the overall
complexity of fund load structures can further overwhelm and confuse
investors.\131\
---------------------------------------------------------------------------
\126\ See, e.g., Roundtable Transcript, supra note 109, at 58
(Paul Haaga, Capital Research Management). See also Comment Letter
of the Independent Directors Council (July 19, 2007) (``IDC
recognizes that one term may not be sufficient given the wide
variety of usage of 12b-1 fees * * *.'').
\127\ See, e.g., Roundtable Transcript, supra note 109, at 141-
54 (multiple commenters). See also Comment Letter of the ICI (July
19, 2007) (``Many commentators * * * questioned the extent to which
investors are aware of the nature and purpose of 12b-1 fees and
suggested that disclosure of the fees and other distribution related
costs can and should be improved. We agree.'').
\128\ See, e.g., Roundtable Transcript, supra note 109, at 121-
22 (Brad Barber, Univ. of Cal., Davis).
\129\ One panelist remarked that the spread load exists because
``it provided a distribution channel for brokers, one that was an
alternative and has many positive characteristics, but also makes
the costs quite non-transparent. And I don't think that is a
coincidence. The growth and use of these funds, at a time when there
was a lot of press around no-load funds, I think there was a reason
brokers wanted to receive their compensation for the services they
provided in a way that did not allow investors to easily put a price
tag on those services.'' Id. at 180-81 (Barbara Roper, Consumer
Federation of America). See also Comment Letter of the National
Association of Personal Financial Advisors (July 17, 2007) (``We
believe that individual investors are confused about the purpose of
12b-1 fees and their impact upon their own returns.'').
\130\ See General Accounting Office (``GAO''), Mutual Fund Fees:
Additional Disclosure Could Encourage Price Competition 75 (June
2000) (observing that investors are more aware of sales loads than
operating expense fees, and are increasingly resistant to paying the
higher front-end loads). See also Todd Houge and Jay Wellman, The
Use and Abuse of Mutual Fund Expenses (Jan. 31, 2006) (academic
working paper) (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=880463) (``While mutual fund investors are often aware of up-
front charges like sales loads, research shows they are often less
cognizant of annual operating expenses, even though both types of
fees are deadweight costs.'').
\131\ See, e.g., Comment Letter of Mark Freeland (June 19, 2007)
(``The complexity of pricing structures makes it more difficult for
the small investor to compare prices and services of different
advisers.''). One commenter expressed concern that the proliferation
of share classes may increase costs to funds and thereby hinder
shareholder returns. See Comment Letter of Bridgeway Funds, Inc. and
Bridgeway Capital Management, Inc. (July 19, 2007) (``[T]his
increase in share classes increases the fund's cost of accounting,
filings, shareholder servicing (e.g., prospectus review, drafting,
printing, mailing), blue sky registration, transfer agency, board
review, etc. These costs are a drain to shareholder returns.'').
---------------------------------------------------------------------------
Many roundtable participants and commenters agreed that rule 12b-1
would benefit from revision, but they differed on the best course for
going forward. Many participants and commenters suggested that the
Commission merely revise the factors for board consideration, or
refashion the role of the board in overseeing 12b-1 fees, to better
reflect the economic realities of fund distribution in today's
market.\132\ Others recommended that the Commission improve disclosure
of 12b-1 fees by changing the name of the fees or, more significantly,
by requiring individualized account statement disclosure of the amount
of 12b-1 fees actually paid by individual shareholders.\133\ Some
suggested, as discussed above, that 12b-1 fees should be
``externalized,'' that is, deducted directly from shareholder accounts
rather than fund assets.\134\ Finally, some commenters argued that rule
12b-1 has outlived its original purpose, and should be substantially
revised or repealed.\135\
---------------------------------------------------------------------------
\132\ See, e.g., Roundtable Transcript, supra note 109, at 50-51
(Joel Goldberg, Willkie Farr & Gallagher) and 201-02 (Mark Fetting,
Legg Mason, Inc.).
\133\ See, e.g., id. at 222-23 (Avi Nachmany, Strategic Insight)
and 154 (John A. Hill, Putnam Funds); Comment Letter of Access Data
Corp. (July 19, 2007) (account-level disclosure of 12b-1 fees is not
cost-prohibitive, and would ``ensure that shareholders have full
disclosure and fee transparency so that they can make an informed
decision related to the fees they pay versus the services they
receive.''). See also GAO, Mutual Funds: Greater transparency needed
in disclosures to investors at 54 (GAO-03-763) (June 9, 2003)
(providing investors with specific dollar amounts of expenses paid
or placing fee-related disclosure in quarterly account statements
could increase fee transparency). But see Comment Letter of W. Hardy
Callcott (June 18, 2007) (individualized disclosure of 12b-1 fees
would entail significant costs and would not, standing alone, be
meaningful to investors). We discuss the costs associated with rule
12b-1 and our proposed amendments in the Cost Benefit Analysis
Section of this Release. See infra Section V.
\134\ See, e.g., Roundtable Transcript, supra note 109, at 204-
06 (Richard Phillips, K&L Gates); Comment Letter of CFA Institute
(Aug. 9, 2004) (File No. S7-09-04) (``We also recommend that funds
be required to deduct distribution-related costs directly from
shareholder accounts as a separate line item, rather than from fund
assets.'').
\135\ See, e.g., Comment Letter of Bridgeway Funds, Inc. and
Bridgeway Capital Management, Inc. (July 19, 2007); Comment Letter
of Lauren Garland (June 2, 2007); Comment Letter of Andrew Gross
(June 9, 2007); Comment Letter of Melvyn H. Mark (June 17, 2007);
Comment Letter of Michael Murray (June 21, 2007). See also Comment
Letter of JoNell Hermanson (July 9, 2007) (stating that variable
insurance products should not be permitted to charge 12b-1 fees);
Comment Letter of Steve Wiands (Aug. 6, 2007) (stating that funds
closed to new investors should not be permitted to charge 12b-1
fees).
---------------------------------------------------------------------------
Roundtable participants generally agreed that 12b-1 fees currently
are used to an extent and in ways that are different than originally
envisioned.\136\ This has caused a ``disconnect'' to develop between
the requirements of the rule and its application. For example,
roundtable participants were in general agreement that the nine
``factors'' that the Commission provided as guidance to the board are
no longer as relevant to the current uses of 12b-1 fees. They stated
that the ensuing legal uncertainties have made it more difficult for
directors to perform their duties and make their required findings
under the rule.\137\ They also said that, although directors complete
the required analysis, they tend to view 12b-1 fees as a necessity--
either to recoup outlays already made or to pay intermediaries at a
rate already decided by the intermediary or the marketplace--to the
point that 12b-1 plans tend always to be continued from year to
year.\138\
---------------------------------------------------------------------------
\136\ See, e.g., Roundtable Transcript, supra note 109, at 192
(Richard Phillips, K&L Gates) and 194 (Mark Fetting, Legg Mason,
Inc.).
\137\ See, e.g., id. at 105 (Robert Uek, MFS Funds) and 158
(John Hill, Putnam Funds). One panelist did not view the factors as
posing a significant obstacle to current distribution arrangements,
however. Id. at 33-34 (Matthew Fink, Former President, ICI) (``The
rule expressly says these factors are suggestions * * *. So the fact
that you may be approving a plan that the purported or suggested
factors don't fit, it's totally irrelevant.'').
\138\ See, e.g., id. at 140 (Jeffrey Keil, Keil Fiduciary
Strategies).
---------------------------------------------------------------------------
Fund directors also observed that, in many instances, they and
their funds lack the bargaining power to effectively negotiate the
level of fees that are paid to financial intermediaries through 12b-1
plans and other sources.\139\ This is particularly true in the case of
fund supermarkets, where the sponsor may charge all participating funds
according to the same rate schedule. These and other statements made at
the roundtable and in the comment letters suggest that one of the
fundamental premises of rule 12b-1--that independent directors would
play an active part in setting distribution fees--does not reflect the
current economic realities of fund distribution and the role 12b-1 fees
play in it.
---------------------------------------------------------------------------
\139\ Cf. Comment Letter of the Independent Directors Council
(July 19, 2007) (``We are not aware of any board that has failed to
renew a 12b-1 plan (or is likely to do so) * * *.'').
---------------------------------------------------------------------------
III. Discussion
We have carefully considered these and other views that emerged
from the roundtable discussion and the many comment letters we
subsequently received. Many of the letters highlighted issues that have
arisen with the current operation of the rule.\140\ We heard
[[Page 47074]]
arguments advocating substantial change in how investors pay
distribution costs, most of which are, at their core, arguments for
greater transparency. We also heard concerns that significant changes
could disrupt arrangements that are today deeply embedded in mutual
fund sales and distribution networks, including those that finance the
operation of fund supermarkets, retirement plan platforms, and
financial planning. These arguments supported the preservation of
business models that were developed around an existing regulatory
framework, but tended to discount some of the more troubling aspects of
distribution arrangements that affect millions of American investors.
We have evaluated all of these views in developing this proposal, which
is designed, as discussed further below, to enhance transparency and
fairness to the benefit of investors.
---------------------------------------------------------------------------
\140\ See supra note 89. Of the nearly 1500 comment letters we
received, over 1400 were sent by financial planners and registered
broker-dealers who opposed substantive reform of rule 12b-1. Of
these 1400 letters, almost 1000 were form letters. See Comment
Letter Type A; Comment Letter Type B. We received approximately 25
letters from mutual funds, large broker-dealer firms, insurance
companies, industry associations, and law firms. The majority of
these letters also opposed significant rule reform, but expressed
various levels of support for changing the name of the fee,
requiring additional disclosure, and revising the role of the fund
board in approving the plan. We received approximately 10 letters
from investors, most of whom supported substantive reform or repeal
of the rule.
---------------------------------------------------------------------------
We do not believe that it would benefit fund investors to return to
the era in which they paid a substantial front-end sales load and did
not have access to various alternative forms of distribution payment
arrangements. Denying investors the ability to select alternate
distribution methods or to pay for distribution services over time is
not a goal of this rulemaking. Thus, we are not proposing in this
rulemaking to prohibit the use of fund assets to pay sales costs. We
remain concerned, however, about the conflicts of interest that arise
when fund assets are used for distribution, and that fund directors
monitor those conflicts. We also do not believe that merely modifying
the ``factors'' for director consideration in order to accommodate
existing industry practices would sufficiently address the issues we
have identified with the use of fund assets to pay for distribution
under rule 12b-1.
Therefore, we are proposing a new approach to asset-based
distribution fees (i.e., 12b-1 fees) that is designed to benefit fund
shareholders while minimizing disruption of current arrangements.
Specifically, our proposal would explicitly recognize that a portion of
asset-based distribution fees (i.e., asset-based sales charges)
functions like a sales load that is paid over time, and thus should be
subject to the requirements and limitations that apply to traditional
sales loads.\141\ Limits on asset-based sales charges would be applied
to the amounts paid by each investor (rather than amounts paid by the
fund) in order to assure that each shareholder would pay only his or
her proportionate share of distribution related costs. In addition, we
propose to require funds to identify for shareholders that portion of
asset-based distribution fees (today's 12b-1 fees) that operates as a
substitute for a sales load and thus facilitate comparison with the
distribution related costs of other funds or classes of shares. The
proposed new rule and rule amendments would replace current rule 12b-1.
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\141\ We acknowledged this, at least implicitly, when we
approved the NASD sales charge rule amendments in 1992. We observed
that the ``purpose of the revised maximum sales charge rule is to
create `approximate economic equivalency' as to the maximum sales
charges for different types of mutual funds.'' See 1992 NASD Rule
Release, supra note 66, at section V. The Commission believed the
amendments would, among other things, promote fairness by assuring
``some degree of parity'' between the sales and sales-promotion
expenses charged by traditional load classes and classes that assess
12b-1 fees. Id.
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We describe the details of our proposals in the next sections of
this Release. In Section III.M of this Release, we describe the
anticipated impact of these proposals on investors, fund managers and
directors, broker-dealers, and other intermediaries.
A. Summary of Our Proposals
The new approach we propose would, like NASD Conduct Rule 2830,
differentiate between the two constituent parts of current 12b-1 fees
(asset-based sales charges and service fees). Under proposed new rule
12b-2, funds could continue to use a limited amount of fund assets to
pay for distribution related expenses.\142\ The maximum amount of this
``marketing and service fee'' would be tied to the service fee limit
imposed by the NASD sales charge rule (currently 25 basis points per
year).\143\ Unlike the service fee, however, funds could use this
portion of fund assets for any distribution related expenses. This
approach would serve the interests of investors and other members of
the fund marketplace by providing a means of paying for participation
in fund supermarkets and the maintenance of shareholder accounts, among
other things, and allowing funds to support their own marketing and
distribution strategies.
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\142\ Proposed rule 12b-2(b).
\143\ Proposed rule 12b-2(b)(1); NASD Conduct Rule 2830(d)(5).
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We also propose to permit funds to deduct from fund assets amounts
in excess of the marketing and service fee, and we would treat these
amounts as an alternative means to pay a front-end sales load. To
accomplish this, we propose to amend rule 6c-10 (which permits funds to
charge deferred loads) to permit this asset-based sales charge, which
we would call an ``ongoing sales charge.'' The proposed amendments in
effect would treat ongoing sales charges as another form of sales load.
Our proposed amendment to rule 6c-10 would not require any special
board findings (such as those required by rule 12b-1), a written plan,
annual renewal, or automatic termination provisions, or impose fund
governance requirements. Instead, we would apply limits on asset-based
sales charges by referencing the front-end load imposed by the fund or,
if none, by referencing the aggregate sales load cap imposed under the
NASD sales charge rule for funds with an asset-based sales charge and
service fee (currently 6.25 percent).\144\
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\144\ NASD Conduct Rule 2830(d)(2)(A).
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These limits would be based on the cumulative amount of sales
charges that an investor pays in any form (front-end, deferred, or
asset-based). Under the proposed rule amendment, a fund imposing an
ongoing sales charge would be required to automatically convert fund
shares to a class of shares without an ongoing sales charge no later
than when the investor has paid cumulative charges that approximate the
amount the investor otherwise would have paid through a traditional
front-end load (or, if none, the NASD rule 6.25 percent cap).\145\ The
proposed amendment would shift the focus of the limits from how much
fund underwriters may collect in asset-based sales charges (a fund-
level cap) to how much individual shareholders will pay either directly
or indirectly (a shareholder account-level cap).
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\145\ See infra note 171 and accompanying text.
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We are also proposing to amend rule 6c-10 to permit an alternative,
elective distribution model. In this new model, intermediaries of funds
could impose charges for sales of the fund's shares at negotiated
rates, much like they charge commissions on sales of exchange-traded
funds (ETFs) \146\ and other equity securities. The proposed rule would
permit fund intermediaries to charge sales loads other than those
established by the fund underwriter and disclosed in the fund
prospectus.
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\146\ ETFs are registered investment companies that offer public
investors an undivided interest in a pool of securities. They are
similar in many ways to traditional mutual funds, except that shares
in an ETF can be bought and sold throughout the day through a
broker-dealer, like stocks traded on an exchange.
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[[Page 47075]]
B. Rescission of Rule 12b-1
We propose, first, to rescind rule 12b-1 in its entirety.\147\ As
we discussed in detail above, rule 12b-1 was adopted in response to a
set of problems identified by the Commission in the late 1970s. But
many of the assumptions underlying the rule appear to no longer reflect
current marketplace realities, including the role that 12b-1 fees play
in the distribution of fund shares and the tasks that directors should
be required to undertake in considering whether to approve 12b-1 fees.
Moreover, the rule has confounded many investors who remain unsure what
a ``12b-1 fee'' is, how it impacts their account, and whether they
should be willing to invest in a fund that imposes such a fee. Finally,
the application of rule 12b-1 today reflects the confusion that has
accumulated over the years as lawyers have sought to provide answers to
questions that have arisen in the course of the rule's evolution.
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\147\ As discussed in more detail in Section III.N of this
Release, we are proposing a grandfathering provision that would
permit funds to deduct existing 12b-1 fees with respect to shares
issued prior to the compliance date for the proposed new rule and
rule amendments, which we anticipate would be at least 18 months
from the effective date in the adopting release.
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Therefore, we have decided not to propose to amend existing rule
12b-1, but to propose a new regulatory framework to address how fund
assets may be used to finance distribution costs.\148\ We believe the
proposed rules, as described in more detail below, would better address
current investor protection concerns raised by the use of fund assets
as alternatives to sales loads and as a means of financing other types
of distribution costs.
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\148\ Although we propose to rescind rule 12b-1, proposed rule
12b-2 retains the section in rule 12b-1 that restricts certain
directed brokerage practices. See 2004 Rule 12b-1 Amendments
Adopting Release, supra note 106. We believe that the concerns we
discussed in that adopting release regarding using directed
brokerage to finance the distribution of fund shares continue to
apply under our new proposal, and we propose to retain the section
we adopted in 2004 unchanged. See proposed rule 12b-2(c).
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We note that Regulation R under the Exchange Act,\149\ which
provides banks exceptions and exemptions from broker-dealer
registration, specifically references fees that banks and their
employees receive pursuant to plans under rule 12b-1.\150\
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\149\ 17 CFR Part 247.
\150\ 17 CFR 247.721(a)(4)(iii)(A), 247.760(c).
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We have not intended that the proposed rule affect those
exceptions and exemptions, and we request comment on whether further
rulemaking, clarification, or interpretive guidance is necessary or
appropriate in this regard.
C. Proposed Rule 12b-2: The Marketing and Service Fee
We propose a new rule 12b-2, which would permit funds, with respect
to any class of fund shares, to deduct a fee of up to the NASD service
fee limit (which is 25 basis points or 0.25 percent annually) from fund
assets to pay for distribution activities, without being subject to the
limitations on sales loads that we describe in the next section of this
Release.\151\ Although the fee could be used for any type of
distribution cost, we anticipate it primarily would be used to pay for
servicing fees of the type currently permitted by the NASD sales charge
rule,\152\ trail commissions to broker-dealers selling fund shares, and
other expenses, such as fees paid to fund supermarkets, that may in
part be distribution related.\153\ This proposed rule would permit
funds to bear expenses similar to those that fund boards generally
approved shortly after our adoption of rule 12b-1 in 1980.\154\
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\151\ Proposed rule 12b-2(b).
\152\ See NASD Sales Charge Rule Q&A, supra note 73, at question
17 (explaining the types of activities for which services fees may
be used).
\153\ As discussed above, we have previously stated that funds
may pay for non-distribution expenses under rule 12b-1 plans. See
supra note 43 and accompanying text. Fund expenditures under current
12b-1 plans often pay for a mixture of distribution and
administrative services. For example, some funds may pay their
entire fund supermarket fee under a rule 12b-1 plan, even though
portions of the fee may pay for administrative services that are not
distribution related. A fund need not determine which portion of the
fee is primarily for distribution services or which portion is
primarily for administrative services, and it may be impractical and
burdensome to require funds to allocate expenses. See Martin G.
Byrne, The Payment of Fund Supermarket Fees By Investment Companies,
3 Investment Law. 2 (1996) (``[B]ecause the services that are
provided to a fund in a supermarket are a combination of
distribution, subaccounting, administrative, account maintenance,
and other shareholder services, some portion of [a supermarket fee]
may be considered a payment `primarily intended' to result in sales
of a fund's shares pursuant to Rule 12b-1 .* * * Because a fund with
a Rule 12b-1 plan is expressly permitted to pay for distribution
services, it is not critical to determine whether a particular
service it pays for in connection with [a supermarket fee] is or is
not for distribution.''). Similarly, proposed rule 12b-2 would not
preclude funds from paying for these types of mixed expenses under
rule 12b-2. However, to the extent that funds need not rely on
proposed rule 12b-2 to charge expenses that can clearly be
identified as not distribution related (e.g., sub-transfer agency
fees), funds could instead characterize those expenses as
administrative expenses and thus keep total asset-based distribution
fees within the 25 basis point limit of the marketing and service
fee. See 1988 Release, supra note 28, at n.126 (``[T]o the extent a
fund is paying for legitimate non-distribution services, such
payments need not be made under a 12b-1 plan, even if the recipient
of the payments is also involved in the distribution of fund
shares.''). See also supra Section III.C of this Release.
Conversely, simply characterizing an activity as ``administrative''
would not permit a fund to pay for it entirely outside of proposed
rule 12b-2 if all or a portion of the fee is distribution related.
See, e.g., In the Matter of BISYS Fund Services, Inc., Investment
Company Act Release No. 27500 (Sept. 26, 2006) (Commission order
instituting settled administrative and cease-and-desist proceedings
arising out of the improper use of fund assets for marketing and
other expenses).
\154\ See supra note 55.
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Unlike rule 12b-1, rule 12b-2 would not require directors to adopt
or renew a ``plan'' or make any special findings.\155\ Rather, fund
boards would have the ability to authorize the use of fund assets to
finance distribution activities consistent with the limits of the rule
and their fiduciary obligations to the fund and fund shareholders.\156\
A plan would not be required under our proposal because the proposed
rules and rule amendments are structured to impose limits and
safeguards on the use of fund assets for distribution, without the need
for board approval of a plan. We intend that the board (including the
independent directors) would oversee the amount and uses of these fees
in the same manner that it oversees the use of fund assets to pay any
other fund operating expenses, particularly those that create a
potential conflict of interest for the fund's investment adviser or
other affiliated persons.\157\ The rule
[[Page 47076]]
would recognize that funds bear ongoing expenses that, although they
are distribution related, may benefit the fund and existing fund
shareholders in a variety of ways. The marketing and service fee would
be specifically identified and fully disclosed in the fund prospectus
fee table as a type of operating expense.\158\
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\155\ Some funds and fund boards have adopted so-called
``defensive'' rule 12b-1 plans that do not impose distribution fees
on the fund, but are designed to ensure that the board and the fund
do not violate the Act if fund expenditures are subsequently
determined to be primarily intended to result in the sale of fund
shares. See ICI, Report of the Working Group on Rule 12b-1 at n.71
(May 2007) (http://www.ici.org/pdf/rpt_07_12b-1.pdf). Although
12b-1 plans (including ``defensive'' ones) would no longer be
required to be entered into under our proposed amendments, the
exemption provided by rule 12b-2 could serve the same purpose as a
defensive plan to the extent that the amount of assets permitted to
be used for distribution under rule 12b-2 has not otherwise been
fully utilized.
\156\ Section 36(a) of the Act ``establish[es] a federal
standard of fiduciary duty'' in dealings between a mutual fund and
certain other persons, including its adviser, principal underwriter,
officers and directors, among others. See Tannenbaum v. Zeller, 552
F.2d 402, 416 (2d Cir.), cert. denied, 434 U.S. 934 (1977). Section
36(a) applies to acts or practices constituting a breach of
fiduciary duty involving ``personal misconduct'' on the part of the
person acting for or serving the fund in the enumerated capacities.
This federal standard is at least as stringent as standards of care
prescribed for fiduciaries under common law, such as the duty of
care and the duty of loyalty. See id. at n.20. See also Commission
Guidance Regarding the Duties and Responsibilities of Investment
Company Boards of Directors with Respect to Investment Adviser
Portfolio Trading Practices, Investment Company Act Release No.
28345 (July 30, 2008) [73 FR 45646 (Aug. 6, 2008)] at section titled
``Summary of Law Regarding Fiduciary Responsibilities of Investment
Company Directors'' (discussing state and federal law fiduciary
obligations of fund directors).
\157\ Congress intended that independent directors play a
critical role in overseeing fund operations and protecting the
interests of shareholders in view of the substantial conflicts of
interest that exist between a fund and its investment adviser. See
House Hearings, supra note 26, at 109; Burks v. Lasker, 441 U.S. 471
(1979). When possible conflicts are present, fund management is
under a duty to fully and effectively disclose information
sufficient for the independent directors to exercise informed
discretion on the matters put before them. See, e.g., Tannenbaum,
522 F.2d at 417, citing Fogel v. Chestnutt, 533 F.2d 731, 745 (2d
Cir. 1975), cert. denied, 429 U.S. 824 (1976) and Moses v. Burgin,
445 F.2d 369 (1st Cir.), cert. denied, 404 U.S. 994 (1971).
\158\ We are proposing amendments to the prospectus fee table,
which are discussed in Section III.J of this Release, infra. We are
also proposing to require funds imposing a new marketing and service
fee, or increasing the rate of an existing 12b-1 fee that would be
used as a marketing and service fee, to obtain the approval of their
shareholders. This requirement is discussed in Section III.F of this
Release, infra.
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Funds may use the proceeds of the marketing and service fee to pay
for, for example, the ongoing cost of participation on a distribution
platform such as a fund supermarket, giving investors a convenient way
of buying shares; for paying trail commissions to broker-dealers in
recognition of the ongoing services they provide to fund investors; or
for paying retirement plan administrators for the services they provide
participants (and which relieve the fund from providing such services).
In addition, funds (including no-load funds) may use the marketing and
service fee to pay for shareholder call centers, compensation of
underwriters, advertising, printing and mailing of prospectuses to
other than current (i.e., prospective) shareholders, and other
traditional distribution activities.\159\
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\159\ See proposed rule 12b-2(b), (e).
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Under the proposed rule, the marketing and service fee could not,
on an annual basis, exceed the limits on service fees prescribed by the
NASD sales charge rule (currently 0.25 percent of fund net assets
annually). Any charge in excess of 0.25 percent per year would be
considered an asset-based sales charge and subject to the overall sales
load limitations established by the NASD sales charge rule and other
requirements, as discussed in the next section of this Release. We
chose to propose this limit because it would permit, without change,
the continuation of many important uses of 12b-1 fees that may benefit
investors. It also represents the line the NASD sales charge rule draws
between a limited distribution fee and a sales charge--25 basis points
currently is the limit that a fund may deduct and still call itself a
``no-load'' fund.\160\ The NASD drew upon its knowledge and expertise
as the self-regulatory organization of the brokerage industry to
develop these limits, which we approved as an appropriate exercise of
the NASD's congressional mandate to prevent excessive sales charges on
mutual fund shares.\161\ Accordingly, we have used the NASD limit on
service fees in formulating our proposal to distinguish a limited
distribution fee from a sales charge.
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\160\ Specifically, NASD Conduct Rule 2830(d)(4) prohibits any
member from describing a fund as ``no-load'' if the fund has
combined asset-based sales charges and services fees of more than
0.25 percent of average annual net assets. This provision is
intended to help investors distinguish between funds that use
relatively small 12b-1 fees to finance advertising and other sales
promotion activities, similar to traditional no-load funds, and
funds that use larger 12b-1 fees as alternatives to front-end sales
loads. See 1992 NASD Rule Release, supra note 66. See also The
Vanguard Group, supra note 31 (order permitting the Vanguard Group
to call its funds no-load even though they made small distribution
payments of 0.20% of average annual net assets).
\161\ See 1992 NASD Rule Release, supra note 66, at section V;
15 U.S.C. 80a-22(b).
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We request comment on the proposal to limit the marketing and
service fee to the maximum service fee permitted under the NASD sales
charge rule.
Would a different term, such as ``sales/service fee,'' be
more appropriate? If so, why? Would a different limit be more
appropriate? Should the limit be higher (e.g., 30 or 50 basis points)
or lower (e.g., 10 or 20 basis points)? If so, why? Should the limit be
set with reference to the NASD rule, which would allow the NASD (now
FINRA) to change the level, pending approval by the Commission?
We understand that many share classes either do not currently
charge 12b-1 fees in an amount that exceeds 25 basis points, or charge
none at all.\162\ Many funds use these fees to compensate
intermediaries for providing customers with follow-up information and
account maintenance services pursuant to the NASD sales charge rule. In
such cases, the shareholder service fees may in fact have a significant
distribution component, which is why funds often pay them pursuant to a
rule 12b-1 plan.\163\ We do not propose, however, to limit the use of
the marketing and service fee to these types of services (i.e., those
described in the NASD sales charge rule), so that funds may continue to
use fund assets to pay for promotional and advertising expenses.
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\162\ See infra Section III.M.2 of this Release.
\163\ See SEC, Mutual Fund Fees and Expenses (2007) (http://www.sec.gov/answers/mffees.htm). Funds may decide that the stream of
payments to a broker-dealer for providing client services (that it
would have provided anyway) could be viewed as an incentive for the
broker-dealer to continue selling the fund.
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Should we limit the marketing and service fee to expenses
incurred for ``shareholder services'' as defined in the NASD sales
charge rule? More generally, do investors in omnibus accounts receive
equivalent levels of service relative to investors who invest directly
and pay similar 12b-1 fees? Is there a disparity in service, and if so,
why? What implications does this have for our proposal?
Under the proposal, ``distribution activity'' would be defined as
``any activity that is primarily intended to result in the sale of
shares issued by the 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.'' \164\ The proposed rule does not attempt to delineate
permissible distribution expenses because our experience with rule 12b-
1 has shown that new distribution methods continually evolve.
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\164\ Proposed rule 12b-2(e)(2). The proposed definition of
``distribution activity'' is identical to the description of
distribution in rule 12b-1. See rule 12b-1(a)(2). Because funds
continually market themselves to investors, many types of activities
may potentially be construed as ``primarily intended'' to result in
fund sales. Although the definition provides flexibility, similar to
rule 12b-1, distribution activities paid for through asset-based
distribution fees under proposed rule 12b-2 and the proposed
amendment to rule 6c-10 (as under rule 12b-1) must represent
legitimate expenses of the fund. See, e.g., Exemptions for Certain
Registered Open-End Management Investment Companies to Impose
Deferred Sales Loads, Investment Company Act Release No. 16619 at n.
3 (Nov. 2, 1988) [53 FR 45275 (Nov. 9, 1988)].
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Are the identified activities appropriately considered
``distribution activities''? Should we provide more guidance regarding
specific expenditures that are distribution expenses and others that
are not, as some commenters have suggested? \165\ Should we define
``distribution activity'' differently? If so, how should we define it?
Should funds be permitted to classify only certain expenses as
marketing and service fees? \166\ If so, what types of expenses?
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\165\ See, e.g., Roundtable Transcript, supra note 109, at 167
(Jeffrey Keil, Keil Fiduciary Strategies) (``[D]istribution
expenditures should be defined in some way, shape, or form, or [the
rule should] say what's not a distribution expenditure.'').
\166\ See, e.g., 2004 Rule 12b-1 Amendments Adopting Release,
supra note 106.
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[[Page 47077]]
D. Proposed Amendments to Rule 6c-10: The Ongoing Sales Charge
The proposed amendments to rule 6c-10 would permit funds to deduct
asset-based distribution fees in excess of the amount permitted under
rule 12b-2 (i.e., 25 basis points annually), provided that the excess
amount is considered an ``ongoing sales charge'' subject to the sales
charge restrictions described below, including an automatic conversion
feature.\167\ Funds would not have to adopt a ``plan'' in order to
impose an ongoing sales charge, and fund boards would not be required
to make any special findings. In short, the proposed rule would treat
ongoing sales charges as another form of deferred sales load.\168\
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\167\ Proposed rule 6c-10(b). We would title this section of the
rule ``Fund-Level Sales Charge'' to distinguish it from a current
provision of rule 6c-10 that provides an exemption to permit funds
to deduct a ``Deferred Sales Load'' (e.g., CDSL) (rule 6c-10(a) from
shareholder accounts, and a proposed alternative that would provide
an exemption from section 22(d) of the Act to permit broker-dealers
to deduct ``Account-Level Sales Charges'' (proposed rule 6c-10(c)).
\168\ As a form of deferred sales load, all payments of ongoing
sales charges to intermediaries would constitute transaction-based
compensation. Intermediaries receiving those payments thus would
need to register as broker-dealers under section 15 of the Exchange
Act unless they can avail themselves of an exception or exemption
from registration. Marketing and service fees paid to an
intermediary may similarly require the intermediary to register
under the Exchange Act.
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Under the proposed provision, a fund could deduct an ongoing sales
charge to finance distribution activities at a rate established by the
fund, provided that the cumulative amount of sales charges the investor
pays on any purchase of fund shares does not exceed the amount of the
highest front-end load that the investor would have paid had the
investor invested in another class of shares of the same fund.\169\ For
example, if a fund has class A shares with a six percent front-end
sales load, the fund could pay as much as six percent in total ongoing
sales charges in class B shares. If another class of shares charges a
front-end sales load of, for example, two percent, a total ongoing
sales charge of as much as four percent could also be charged (six
percent minus the two percent front-end load) with respect to that
class.
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\169\ Proposed rule 6c-10(b)(1).
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We seek comment on whether the Commission should treat ongoing
sales charges as a form of deferred sales load subject to the NASD
sales charge limitations. We also seek comment on whether the proposed
amendments to rule 6c-10, as described in more detail below, accomplish
this goal.
Do the sales charge limitations, as we propose to apply
them, adequately protect investors from excessive sales loads in
accordance with the objectives of section 22(b) of the Act? Would any
aspect of these proposed sales charge limitations encourage broker-
dealers to recommend ``switching'' between fund families once an
investor has reached the ongoing sale charge limits? If so, does this
proposal raise any issues (that do not already exist with regard to
other classes) that would encourage such switching, in light of current
NASD sales charge limits? What effect could the proposed rule have on
the various types of share classes currently offered by funds? For
example, would funds or distributors reduce, eliminate, or increase the
offering of share classes with asset-based sales charges? To the extent
that broker-dealers rely on ongoing sales charges as compensation for
ongoing services to investors, could the quantity or quality of the
services provided change if the rule results in limits on cumulative
ongoing sales charges?
1. Automatic Conversion
Under the proposed amendments, funds or fund intermediaries would
not be required to keep track of the actual dollar amount of ongoing
sales charges paid by each individual shareholder account (although
they may choose to do so) to avoid exceeding the rule's maximum sales
charge limitation.\170\ A fund could satisfy the maximum sales charge
limitation by providing that the shares purchased would automatically
convert to another class of shares without an ongoing sales charge no
later than the end of the month during which the fund would have paid
on behalf of the investor the maximum amount of permitted sales load
based on the cumulative rates charged each year.\171\ In addition, a
fund could impose a CDSL in combination with an ongoing sales charge,
but total sales charges could not exceed the maximum sales charge
limitation.\172\
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\170\ We understand that many funds lack the ability to track
dollar amounts of distribution expenses charged to purchases by
individual investors.
\171\ Proposed rule 6c-10(b)(1)(i) (providing that a fund may
comply with the maximum sales charge limits by converting shares on
or before the end of the conversion period); proposed rule 6c-
10(d)(2) (defining ``conversion period'' as ``the period beginning
on the day that shares are purchased and ending on the last day of
the calendar month during which the cumulative ongoing sales charge
rates exceed the shareholder's maximum sales load rate''). The rule
would permit conversion periods to be computed as of the end of the
calendar month because that would conform to the way most funds
presently compute conversion periods with respect to class B shares.
Thus, for example, the provision would operate as follows:
Assume that a fund offers a class A share with a 6% front-end load
and no ongoing sales charge. The same fund could also offer a class
of C shares with an annual ongoing sales charge of 0.75%, provided
that: (i) The class C shares convert to class A shares in 96 months
or earlier ([6.0% / 0.75%] x 12 = 96 months or 8 years); and (ii)
the class C shares do not impose any other loads.
\172\ Using the example in note 171, supra, a fund offering a
class A share with a 6% front-end load could also offer a class B
share that is 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 on. 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.
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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 three percent,
the ongoing sales charge could be 50 basis points annually for six
years. Alternatively, the fund could collect 25 basis points annually
for 12 years, 75 basis points annually for four years, 150 basis points
annually for two years, and so on.
We have designed the conversion provisions of the rule so that the
maximum conversion date is easily determinable at the time the investor
purchases fund shares (as is a front-end sales load).\173\ As a result,
the fund or intermediary would be able to provide this information to
an investor or a prospective investor at the time he or she makes or is
considering making an investment in the fund.\174\ We propose monthly
conversions because they reflect the current practices of many funds
and fund transfer agents, which we anticipate would reduce costs
associated with complying with the proposed rules.
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\173\ Funds could sell shares subject to a shorter conversion
period than the maximum conversion period as defined under the
proposed rule. In addition, funds could offer scheduled variations
in the conversion period to a particular class of shareholders or
transactions if the fund has satisfied the conditions in rule 22d-1.
Proposed rule 6c-10(b)(1)(iii). Nothing in the rule would prevent a
fund from offering to existing shareholders a new scheduled
variation that would reduce the conversion period. Proposed rule 6c-
10(b)(2). These provisions are similar to provisions that currently
apply to deferred sales loads under rule 6c-10, and which are
included in proposed rule 6c-10(a). See proposed rule 6c-
10(a)(1)(iii) and (a)(2).
\174\ See infra Section III.D.1.b of this Release.
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We request comment on alternatives, such as daily, weekly,
or quarterly conversions.
[[Page 47078]]
a. Differences From NASD Cap
Our proposed shareholder account-level cap would effectively
replace the NASD fund-level cap on asset-based sales charges.\175\ In
proposing a fund-level cap in 1991, the NASD explained that it had
considered a shareholder account-level cap but, at the time, it
believed that an account-level cap would require individual shareholder
accounting, and in light of the difficulties involved with individual
shareholder accounting, concluded that an account-level cap was not
feasible.\176\ The NASD acknowledged, however, that while its' approach
``protects a majority of shareholders,'' it also ``may result in a
minority of long-term shareholders paying more than the maximum sales
charge.'' \177\ To illustrate, a fund shareholder paying a five percent
front-end load on an investment of $10,000 in a fund will pay a $500
sales load, but the same investor investing in a fund with a (not
uncommon) 12b-1 fee of 100 basis points, over a period of 10 years,
could pay more than $800 in distribution related sales charges
(resulting from the 75 basis point asset-based sales charge
component).\178\ After 20 years, the difference becomes more
significant: The shareholder would have paid $2,292 in asset-based
sales charges compared with the $500 front-end load.
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\175\ See supra Section II.C.1 of this Release.
\176\ See NASD Notice of Proposed Rule Change, supra note 74, at
section titled ``Method of Calculating the Total Sales Charges''
(``Requiring the individual shareholder accounting method would
mandate extensive and expensive changes in the recordkeeping methods
and procedures utilized by mutual funds, would disrupt current
processing of sales and redemptions, and would take several years
for the industry to achieve.'').
\177\ Id. The NASD considered fund-level accounting to be the
``best alternative as a minimum standard at [the] time.'' Id. The
NASD also noted that the industry as a whole would not be prevented
from adopting ``more protective methods'' in the future. Id.
\178\ Assuming a $10,000 initial investment and an annual return
of five percent, the front-end load shareholder would have an
account balance after ten years of $15,474; the shareholder in the
fund with the 12b-1 fee would have an account balance of $15,162--a
deficit of $312 that is attributable to the 75 basis point asset-
based sales charge component of the 12b-1 fee. Put another way,
rather than paying a $500 sales load, the shareholder has paid over
$800 in asset-based sales charges.
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The NASD's Mutual Fund Task Force, in its report on mutual fund
distribution issues, expressed similar concerns when it identified
limitations on the length of B share conversion periods as a potential
area for regulatory reform.\179\ Our proposal would address both the
fairness concerns raised by the NASD Task Force in 2005 and the
operational concerns raised in 1991 by avoiding the need for individual
shareholder accounting. We view our proposal in many respects as the
further development of the NASD sales charge rule, which was intended
to bring total 12b-1 fees into ``approximate economic equivalency''
with traditional loads, although this equivalency would not be exact,
as a result of potential varying volume discounts between share classes
and differing market returns.\180\
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\179\ See NASD, Report of the Mutual Fund Task Force: Mutual
Fund Distribution at 18 (2005) (http://www.finra.org/web/roups/rules-regs/documents/rules-regs?p013690.pdf).
\180\ See NASD Notice of Proposed Rule Change, supra note 74.
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b. Implications on Fund Operations
Our proposed account-level cap would build upon innovations of fund
management companies that have developed the operational capacity to
issue, track the aging of, and convert class B shares. As a result, we
expect that funds and intermediaries will be able to utilize existing
transfer agency and other recordkeeping systems that administer funds
issuing class B shares, which we believe operate in a manner similar to
the proposed conversion provision or could be easily adjusted to do
so.\181\ In addition, we have sought to provide funds the flexibility
to design different sales load structures that meet the needs of fund
investors, funds, and their distribution systems. Accordingly, we do
not propose to specify the annual maximum rate at which a fund could
deduct annual ongoing sales charges.\182\
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\181\ As discussed above, funds today are selling many fewer B
class shares than just a few years ago. Because systems must remain
in place to meet the operational requirements of a single
outstanding B class share, this trend should not affect the ability
of fund management companies or their service providers to make use
of existing systems to convert existing class C shares or other
classes.
\182\ The NASD sales charge rule currently caps these fees at 75
basis points annually. However, if our proposed rule changes are
adopted, the annual cap may be unnecessary because the cumulative
amount of ongoing sales charges would be capped.
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We request comment on the operational implications of the proposed
automatic conversion.
Can existing fund and intermediary systems be adapted so
that conversion periods could be readily determined and implemented at
the time of purchase? How easy or difficult would this adaptation be?
How difficult would it be for funds that don't currently offer B shares
to develop such systems? Is the flexibility we propose advantageous, or
would a more standardized approach be more easily understood by, and in
the interest of, investors? How would a more standardized approach
work?
c. Implications on Transferability of Shareholder Accounts
The proposed automatic conversion feature, and its attendant
requirement to track fund shares, may present additional issues when
shareholder accounts are transferred between different intermediaries.
We understand that, in some cases, tracking fund shares is a
responsibility assumed by the fund transfer agent, in which case the
portability of fund shares (i.e., the ability of an investor to move
his account from one intermediary to another) should not be affected.
In other cases (e.g., where the shares are held in omnibus accounts),
fund intermediaries track share lots and would need to provide share
lot histories to the new intermediary for the new intermediary to be
able to determine the remaining maximum sales charge for transferred
shares.\183\ We understand that fund intermediaries today have the
ability to transfer share lot histories in order to: (i) Service class
B shares or classes with contingent deferred sales loads, and (ii) meet
tax reporting requirements. Thus, we do not believe that our proposals
would interfere with the ability of a shareholder to transfer shares
from one intermediary to another.
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\183\ Such a transfer is unlikely to be an ``offer of exchange''
under section 11 of the Act, which applies only to offers by a fund
or a principal underwriter of a fund. Accordingly, the ``tacking''
provisions of rule 11a-3 would not apply, and any aging of fund
shares that a new intermediary might do would not be done to satisfy
any requirement of the Act. See infra Section III.K of this Release.
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We request comment on our assumptions in this area.
Would the proposed rule's conversion requirement present
any special problems when shares are transferred between customer
accounts held at different intermediaries? Are there different
implications with respect to different types of intermediaries and, if
so, what are they? Is there any reason that some intermediaries would
not be capable of transferring share lot history?\184\ Are there other
provisions that we should consider that would facilitate
transferability?
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\184\ We understand that some intermediaries, such as retirement
plans and insurance companies, may not even track share lot history.
Those situations present additional issues, which are discussed in
Sections III.H and III.M.5 of this Release, infra.
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2. The Maximum Load
a. The Reference Load
We propose that the maximum sales load that would apply to any
purchase of shares in a fund class subject to an ongoing sales charge
would be the highest front-end load of another class of that fund that
does not charge an
[[Page 47079]]
ongoing sales charge, and which would act as a ``reference load.''
\185\ If a fund offers a class of A shares, the maximum amount of sales
charges it could collect from an investor in B or C share classes would
be the amount the investor would have paid had the investor invested in
A shares with the maximum front-end load.\186\ By setting the maximum
front-end load, the fund, its board, and the principal underwriter
would also establish the maximum amount of the cumulative ongoing sales
charge.\187\
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\185\ Proposed rule 6c-10(d)(14)(i). In the case of shares
exchanged within the same fund group, the proposed rule provides
that the reference load is the highest applicable sales load of the
exchanged or acquired security. Proposed rule 6c-10(d)(14)(ii).
\186\ Under the proposed rule, the shareholder's maximum sales
load would be reduced if the shareholder previously paid a sales
load on fund shares that the shareholder subsequently exchanged for
shares of the current fund. Fund shareholders would also be credited
for any other sales loads they paid on a particular share purchase.
Thus, the maximum sales load rate that an investor could be charged
would be defined under the proposed rule as the reference load minus
the sum of the rates of: (i) Any sales load incurred by the
shareholder in connection with the purchase of fund shares, and (ii)
any other sales loads or ongoing sales charges attributable to
exchanged shares. Proposed rule 6c-10(d)(10). This approach is
consistent with the approach the Commission has taken in
implementing section 11 of the Act. Specifically, rule 11a-3 governs
sales loads and other charges that may be imposed on an exchange
between funds within the same fund group, and is intended to help
ensure that shareholders receive credit for all sales charges
incurred on a particular purchase of fund shares and are protected
from the sales practice abuse of switching, i.e., the practice of
inducing shareholders of one fund to exchange their shares for those
of a different fund solely for the purpose of exacting additional
sales charges. See Offers of Exchange Involving Registered Open-End
Investment Companies, Investment Company Act Release No. 17097 (Aug.
3, 1989) [54 FR 35177 (Aug. 24, 1989)] (``Rule 11a-3 Adopting
Release''). We have also proposed conforming changes to rule 11a-3,
as discussed in Section III.K of this Release, infra.
\187\ See also infra Section III.D.2.d.4.
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As we noted above, sales loads rarely approach the maximum of 8.5
percent permitted under the NASD sales charge rule,\188\ yet we
understand that rule 12b-1 fees often are charged at the maximum rate
permitted, currently 100 basis points annually.\189\ One reason may be
that 12b-1 fees are deducted in smaller amounts, over longer periods of
time, and indirectly from fund assets, and thus, to investors, they may
be less salient and not as well understood when compared to front-end
sales loads, and the fees themselves appear to be subject to less
market pressure.\190\ Thus, some of our roundtable panelists and
commenters urged that the Commission ``externalize'' asset-based sales
charges (i.e., require that such charges be paid directly from a
shareholder's account, rather than indirectly from fund assets) so that
the amounts investors are paying would be more noticeable and
transparent.\191\ Our proposed approach in rule 6c-10(b) would,
instead, tie the maximum amount of the ongoing sales charge to the
front-end load. To the extent that competitive pressures result in
funds imposing lower front-end loads, these pressures should transfer
to ongoing sales charges and could result in lower charges or charges
that more accurately reflect the value of the distribution services
provided. In addition, this proposed approach is designed to reduce the
potential that some long-term shareholders will pay a significantly
disproportionate share of the distribution costs of a fund.
---------------------------------------------------------------------------
\188\ See NASD Conduct Rule 2830(d)(1)(A).
\189\ See supra note 42. According to statistics compiled by our
staff, 27 percent of funds that impose 12b-1 fees charge a rate of
exactly 100 basis points.
\190\ See Brad M. Barber, Terrance Odean, and Lu Zheng, Out of
Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows, 78
J. Bus. 2095 (Dec. 2003) (mutual fund investors are less willing to
pay higher front-end loads because they are more obvious and
salient, but are less sensitive to annual operating expenses,
including rule 12b-1 fees).
\191\ See, e.g., Roundtable Transcript, supra note 109, at 184-
85 (Richard Phillips, K&L Gates). See infra Section III.I of this
Release regarding an alternative approach we are proposing that
would permit externalized sales charges at the election of funds and
their underwriters.
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We request comment on the definition and function of the reference
load.
Should we establish a maximum limit on the amount of
ongoing sales charge that may be deducted? Could this approach
encourage funds to offer a share class with a high front-end sales load
in order to charge a higher cumulative ongoing sales charge on other
classes? Are the NASD rule's limits on sales charges a sufficient or
appropriate guide for the reference load? The NASD sales charge limits
apply at the fund level on an aggregate basis, whereas the ongoing
sales charge limits of our rule proposal would apply at the level of
individual accounts to limit the cumulative asset-based sales charge
paid by any single investor. Should the proposed rule's reliance on the
NASD sales charge limits be adjusted to take into account the
difference in application? For example, would the proposal's cap have a
more constraining effect on the amount of cumulative ongoing sales
charges deducted by a fund? If so, should the proposal's cap be
increased above the NASD cap to compensate for this? If not, what
should the limits be?
Alternatively, should we assign fund boards the
responsibility of establishing the maximum amount of ongoing sales
charges that a fund may deduct? If so, what standards or factors would
be relevant to their determination?
b. Funds Without a Front-End Load Class
Some funds, of course, might not offer a class of shares with a
front-end load, or might offer the front-end load class with asset-
based distribution fees of more than 25 basis points (thus
disqualifying the front-end load from acting as a reference load). We
are proposing that, in these circumstances, the reference load would be
the maximum sales charge permitted under NASD Conduct Rule 2830(d)(2)
for funds with an asset-based sales charge and a service fee, which
currently is 6.25 percent of the amount invested.\192\
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\192\ Proposed rule 6c-10(d)(14)(iii). Some funds, for example,
offer only a single class of C shares. See also Section II.C.1 of
this Release, supra, for a discussion of the caps under the NASD
sales charge rule.
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We chose this rate because it is the current limit for funds with
this type of sales charge structure under the NASD rule, which we
approved in 1992 as not being excessive.\193\ We believe linking the
reference load to the NASD limits may minimize operational burdens of
the amendment because funds, their underwriters, and broker-dealers are
already familiar with the NASD sales charge rule limits and have
structured their systems accordingly.\194\ Under our proposal, funds
could provide for lower sales loads (through shorter conversion
periods) if they wish.\195\
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\193\ See supra Section II.C.1 of this Release.
\194\ See supra note 161 and accompanying text.
\195\ The rule requires that, at a minimum, shares must convert
on or before the end of the maximum conversion period. Proposed rule
6c-10(b)(1)(i). See also supra notes 171-173 and accompanying text.
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We request comment on whether the rule should permit the
NASD maximum sales charge of 6.25 percent to serve as a default
reference load for funds that do not offer a class of shares without an
ongoing sales charge. If the rule should not permit this limit, what
should be the limit? We are not proposing to use the limits in the NASD
sales charge rule for investment companies without an asset-based sales
charge (as much as 8.5 percent).\196\ This is because, under our
proposed rule, each fund charging an ongoing sales charge by definition
charges an asset-based sales charge of more than 25 basis points. Would
there be any reason to designate these higher limits as a default
reference load under our proposed rule amendment? We note that doing so
may
[[Page 47080]]
further extend conversion periods and, thus, the period of time that
some investors may pay ongoing sales charges.
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\196\ NASD Conduct Rule 2830(d)(1)-(2) (describing the different
sales load limits, ranging between 8.5% and 6.25%, depending on
whether the fund charges an asset-based distribution fee and offers
rights of accumulation and quantity discounts).
---------------------------------------------------------------------------
Under our proposal, funds would be permitted to deduct
total sales charges up to the maximum sales charge permitted under the
NASD sales charge rule. Would our proposed use of the 6.25 percent NASD
limit as a default reference load give an advantage to funds that do
not offer a class of A shares? To avoid this result, should the
Commission identify a ``typical'' maximum front-end sales load that
more closely tracks current industry practice (e.g., four, five or six
percent) and rely on such a sales load as a default reference load when
a fund does not offer a class of A shares? If so, what should that
default reference load be?
We note that in recent years, the costs of trading equity
securities have declined significantly.\197\ In this regard, should the
Commission consider proposing a rule that would establish a new limit
on sales charges, in light of changes in technology and the markets?
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\197\ See United States Government Accountability Office,
Securities Markets: Decimal Pricing Has Contributed to Lower Trading
Costs and a More Challenging Trading Environment, 8-29 (May 2005)
(http://www.gao.gov/new.items/d05535.pdf); see also James Angel,
Lawrence Harris & Chester S. Spatt, Equity Trading in the 21st
Century, 8-13 (USC Marshall School of Business May 18, 2010) (http://ssrn.com/abstract=1584026).
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As an alternative, should we treat the NASD sales charge
limit of 6.25 percent as the reference load for purposes of determining
the maximum amount of ongoing sales charge in all cases, even if a fund
has a front-end load class of shares that can serve as the reference
load? Such an approach would provide economically equivalent treatment
of funds that offer a class of A shares and those that do not. It would
not, however, provide equivalent treatment of investors who choose to
pay a front-end sales load with those that pay an ongoing sales charge.
If the maximum front-end sales load is lower than 6.25 percent,
shareholders in classes with an ongoing sales charge may bear a
disproportionate amount of distribution costs (compared to shareholders
in class A shares).
c. Treatment of Scheduled Variations
The proposed amendments to rule 6c-10 would not require (but would
permit) funds to apply any quantity discounts or scheduled variations
in the front-end load for which the investor may qualify when
determining the reference load for an ongoing sales charge. Investors
who pay asset-based sales charges today as a substitute for a front-end
load generally are not offered any discounts or variations in the
amount of fees they pay indirectly through their investment in the
fund.\198\ We are concerned that requiring funds and their
intermediaries to calculate a different reference load for each
purchase of fund shares would introduce greater cost and complexity and
could affect the willingness of funds and their underwriters to offer
quantity discounts or scheduled variations on front-end sales loads to
investors.
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\198\ Investors nevertheless may prefer to defer the payment of
sales charges rather than paying a front-end sales load in some
circumstances, because a greater portion of their money is invested
immediately in the fund. See Rule 6c-10 Proposing Release, supra
note 57, at section titled ``Discussion.''
---------------------------------------------------------------------------
We request comment on whether funds should be required to
incorporate scheduled variations in the front-end load when determining
a shareholder's reference load.
How would funds likely react to this requirement if we
adopted it? Would this requirement discourage funds from offering
scheduled variations in the front-end load? Would it cause some funds
to discontinue front-end load share classes entirely? Would it
encourage funds to offer share classes with high front-end sales loads
that effectively operate to increase the amount of ongoing sales
charges the fund collects in other share classes? \199\ How would
investors react? Would this requirement affect the number of fund
investors selecting the ongoing sales charge class?
---------------------------------------------------------------------------
\199\ This could occur, for example, if a fund offered a share
class with a front-end load of 8.5 percent but with scheduled
variations at low investment thresholds for investors actually
purchasing that class. This result may be unlikely, however, because
funds would have to disclose the maximum front-end load in fund
performance advertisements and use it to compute the fund's
performance. See, e.g., Rule 482 under the Securities Act [17 CFR
230.482], Rule 34b-1 under the Investment Company Act, and Item
26(b) of Form N-1A. See also NASD Conduct Rule 2210.
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d. Sales Load on Asset Growth
Proposed rule 6c-10(b) would operate so that a fund and its
investors could determine the conversion period at the time the
investor makes a purchase of shares. Each purchase (or each ``lot'')
would have a separate conversion period, and the shares associated with
each lot would be programmed to convert on a particular date. The
maximum length of the conversion period would be unaffected by any
subsequent increase or decrease in the value of the shares purchased.
As a result, the fund underwriter would collect more ongoing sales
charges if the value of the fund shares increased and collect less if
the value decreased.\200\ Shareholders would also benefit from the
growth (or bear the losses) in the value of the fund shares that would
not have otherwise been purchased had the shareholder paid a front-end
sales load.
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\200\ For example, assume that an investor purchased $10,000 of
a class of shares with no front-end sales load and an ongoing sales
charge of 0.75% with an eight-year conversion period. If the
investor obtained an annual rate of return of 5%, he or she would
pay $697 in ongoing sales charges over eight years and have an
account balance of $13,951. If the investor received an annual
return of 10%, he or she would pay $835 in ongoing sales charges and
have an account balance of $20,294. If the investor received a
negative annual return of -5%, he or she would pay $492 in ongoing
sales charges and have an account balance of $6,227 after eight
years.
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We believe that this approach is straightforward, is easy for
investors to understand, is easy to administer, protects shareholders'
interests in the allocation of risks and benefits between the
shareholder and the fund's principal underwriter, and permits funds to
deduct fees for distribution in the same manner that they currently
deduct 12b-1 fees. This approach is different, however, from the
approach currently taken by rule 6c-10 with respect to determining the
maximum amount of a deferred sales load such as a CDSL.\201\ Rule 6c-
10(a)(1) limits the maximum amount of a deferred sales load to an
amount specified at the time the shares were purchased.\202\ Thus, in
the case of deferred sales loads, investors never pay a higher amount
as a result of fund performance.
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\201\ We are also proposing to make certain non-substantive
changes to the heading of current rule 6c-10, and parts of 6c-10(a),
designed to clarify the names and use of the type of sales load
practice discussed, including deferred, fund level, and account-
level sales loads.
\202\ See 1996 Rule 6c-10 Amendments, supra note 58. Prior to
the amendment, rule 6c-10 had required that CDSLs be based on the
lesser of the NAV of the shares at the time of purchase or the NAV
at the time of redemption. We eliminated this requirement, deferring
to the NASD to address such matters in its sales charge rule. At the
same time, we required that the amount of a deferred sales load not
exceed a specified percentage of the NAV of the fund's shares at the
time of purchase so that investors ``be given the benefit, if any,
of deferring the load payment should there be an increase in the
shares' NAV.'' Id. at n.16 and accompanying text.
---------------------------------------------------------------------------
Given that our goal is to treat asset-based sales charges
the same as other deferred sales loads, should we use the same approach
for both? If so, which method should be used? If we require that
ongoing sales charges be based on an amount determined at the time of
purchase, would funds in effect be required to track each individual
shareholder dollar paid in ongoing sales charges? Should we instead
propose to amend rule 6c-10 (proposed rule 6c-10(a)) to permit
underwriters to collect
[[Page 47081]]
higher deferred sales loads as a result of fund performance?
3. Reinvestment of Dividends and Other Distributions
The proposal would permit funds to offer to invest shares acquired
pursuant to a reinvestment of dividends or other distribution in the
same share class as the shares on which the dividend or distribution
was declared. If the share class has an ongoing sales charge, however,
the reinvested shares would have the same conversion period as the
shares on which the dividend or distribution was declared.\203\ As a
result, reinvested shares may incur an ongoing sales charge, but would
convert to a share class without an ongoing sales charge no later than
the conversion date of the shares on which the dividend or distribution
was declared.\204\ This approach would directly benefit investors,
compared to the current approach under the NASD sales charge rule
(which does not limit asset-based distribution fees from being charged
on reinvested dividends indefinitely), because any ongoing sales charge
deducted on reinvested dividends would no longer be charged after the
conversion date of the original shares. This approach also reflects
what we understand to be the practice most fund groups use to account
for reinvestment of distributions on class B shares, and thus would
permit them to avoid incurring costs associated with revising current
fund systems--costs that may ultimately be borne by fund shareholders.
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\203\ See proposed rule 6c-10(b)(1)(ii).
\204\ Id.
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Our proposed approach would be different, however, from the NASD
sales charge rule, which prohibits funds from imposing front-end sales
loads and CDSLs on reinvested dividends.\205\ The reinvestment of
dividends does not involve the expenditure of sales-related efforts,
and the NASD viewed such loads as ``duplicative.'' \206\
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\205\ Proposed rule 6c-10(b)(1)(ii) would address the terms
under which a fund with an ongoing sales charge could reinvest
dividends and other distributions in shares of a class with an
ongoing sale charge.
\206\ NASD Notice to Members 97-48 (Aug. 1997).
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In view of the NASD rule and our intention to treat
ongoing sales charges as another form of sales load, should we instead
require funds to reinvest dividends and other distributions in a share
class that does not have any ongoing sales charge? \207\
---------------------------------------------------------------------------
\207\ See NASD Conduct Rule 2830(d)(6)(B).
---------------------------------------------------------------------------
We request comment on whether we should adopt the proposed
approach or, alternatively, that of the NASD sales charge rule. Would
there be significant costs associated with reinvesting small amounts of
retail investor accounts in a different share class? If we adopt the
proposed approach, should shares acquired through a dividend
reinvestment plan be required to convert before, after, or at the same
time as, the shares on which the dividend or distribution was declared?
More generally, what are the prevailing market practices
with regard to reinvested dividends and other distributions? What is
the annual volume of dividends and distributions offered by funds, and
reinvested by shareholders? What is the magnitude of fees currently
paid by investors on reinvested dividends? Do funds currently offer the
option for investors to reinvest dividends in other share classes?
4. Role of Directors--Proposed Guidance
Unlike rule 12b-1, the proposed amendments to rule 6c-10 would not
impose any explicit responsibilities on fund boards of directors to
approve (or re-approve) asset-based sales charges under the proposed
rule, although we fully expect fund boards would continue to play an
important role in protecting fund investors, as discussed more fully
below. Directors would continue to have fiduciary duties with respect
to the oversight of the use of fund assets under state law and under
section 36(a) of the Act.\208\ When the Commission adopted rule 12b-1
in 1980, we sought to address statutory concerns about the conflict of
interest between fund advisers (who benefit from an increase in the
amount of fund assets) and fund investors (who may not).\209\ We were
concerned about whether a fund and its shareholders would benefit from
a decision to pay distribution costs from fund assets, and viewed such
a decision as ``a particularly difficult business judgment'' that is
complicated by the conflicts of interest which are present.\210\
Therefore, we made these arrangements subject to the careful scrutiny
of fund directors.\211\ Under our proposed approach, each shareholder
would pay indirectly through the deduction of ongoing sales charges by
the fund only the proportionate expenses associated with the sale of
his or her fund shares. When those costs are paid, the shares purchased
would automatically convert to a class of shares not paying an ongoing
sales charge. The fund paying an ongoing sales charge would, in a
sense, operate merely as the vehicle by which the fund shareholder pays
the underwriter what the investor would have paid in the form of a
front-end load at the time shares were purchased. Funds and fund
underwriters would have little incentive to collect ongoing sales
charges at excessive rates--a class of shares paying a higher rate of
ongoing sales charge would simply convert earlier to a class that does
not pay an ongoing sales charge.
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\208\ See supra note 156.
\209\ See 1980 Adopting Release, supra note 23, at section
titled ``Discussion.''
\210\ Id. at section titled ``Independence of Directors.''
\211\ See rule 12b-1(e).
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We view the treatment of the ongoing sales charge as another form
of sales load (together with the automatic conversion requirement) as
critical in our decision not to propose a specific role for the board
of directors, while addressing the underlying concerns of section 12(b)
of the Act. Directors will, however, continue to have fiduciary
obligations under state law and section 36(a) of the Act to consider
whether use of the fund's assets to pay ongoing sales charges, within
the proposed caps, is in the best interest of the fund and fund
investors.\212\ We expect to provide guidance in our adopting release
for this proposal, to assist fund directors in satisfying their
fiduciary duties.
---------------------------------------------------------------------------
\212\ See also supra note 156.
---------------------------------------------------------------------------
We request comment on the following proposed guidance.
We believe that fund directors should consider the amount of the
ongoing sales charge and the purposes for which it is used according to
the same procedures they use to consider and approve the amount of the
fund's other sales charges in the underwriting contract under section
15(c) of the Act.\213\ We further believe that directors can and should
view these asset-based distribution fees as integral parts of the
fund's sales load structure to which they give their assent when they
annually approve the fund's underwriting contract. In determining
whether to approve (or re-approve) the underwriting contract, the
directors must exercise their reasonable business judgment to decide,
among other things, whether the terms of the contract benefit the fund
(or its relevant class) and its shareholders, whether the underwriter's
compensation is fair and reasonable
[[Page 47082]]
(considering the nature, scope and quality of the underwriting services
rendered), and whether the sales loads (including the 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. In
evaluating the ``fairness and reasonableness'' of the contract, the
directors should consider any factors that may be relevant, including
whether the fund's distribution networks and overall structure are
effective in promoting and selling fund shares given current economic
and industry trends, any available breakpoints on advisory fees that
may be attained from future growth in fund assets, and any economies or
diseconomies of scale that may arise from continued growth of fund
assets.\214\
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\213\ Section 15(c) provides, in relevant part, that ``it shall
be unlawful for any registered investment company * * * to enter
into, renew, or perform any contract or agreement * * * whereby a
person undertakes regularly to serve or act as * * * principal
underwriter for such company unless the terms of such contract or
agreement and any renewal thereof have been approved by the vote of
a majority of directors, who are not parties to such contract or
agreement or interested persons of any such party * * *.''
\214\ We understand that many fund boards currently consider
these, or similar, factors when evaluating funds' underwriting
contracts.
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Is this proposed guidance appropriate? Does it provide
assistance to fund directors in evaluating ongoing sales charges? Are
there other factors that would be relevant to the guidance we propose
to provide? Should the guidance link board approval of the principal
underwriting contract to board oversight of the use of fund assets for
an ongoing sales charge? If not, what standard or requirements should
apply to board oversight of ongoing sales charges?
We request comment on our proposed overall approach to
refashioning the role of the board of directors in overseeing asset-
based distribution fees.\215\ Is there a better approach we could take?
Should we retain a formal role for directors in any rule permitting
funds to pay for distribution expenses from fund assets? If so, what
should that role be? Should we retain the current rule 12b-1, but
update the suggested factors for director consideration in order to
provide directors with additional guidance? For example, should the
factors specifically recognize that directors may consider that ongoing
sales charges provide an alternative to a front-end sales load and, in
that sense, benefit shareholders who choose to invest in a share class
that has an ongoing sales charge? Should directors, in addition,
consider whether these arrangements are structured so that individual
shareholders do not bear a disproportionate share of distribution
expenses? In this regard, we are particularly interested in the views
of fund directors.\216\
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\215\ Throughout this proposal we use the term ``Asset-Based
Distribution Fee'' to mean any fee deducted from fund assets to
finance distribution activities pursuant to rule 12b-2(b) (Marketing
and Service Fee), rule 12b-2(d) (Grandfathered 12b-1 Shares), or
rule 6c-10(b) (Ongoing Sales Charge).
\216\ Our proposed approach was informed by input from
independent director representatives. See Comment Letter of the
Independent Directors Council (July 19, 2007) (``IDC believes that
the role of directors in overseeing 12b-1 plans should be consistent
with the role of directors in overseeing front-end sales loads and
fund distribution practices generally.''); Letter from the Mutual
Fund Directors Forum to Andrew J. Donohue, Director of the Division
of Investment Management, Securities and Exchange Commission (May 2,
2008) (http://www.mfdf.com/images/uploads/resources_files/Director_Duties_MFDF_Letter_May_2_2008.pdf) (``the quarterly
review of expenditures under a fund's 12b-1 plan by directors serves
little purpose, particularly since directors can have little impact
in the first place on 12b-1 costs incurred by funds'').
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E. Proposed Amendments to Rule 10b-10: Transaction Confirmations
Rule 10b-10 under the Securities Exchange Act requires broker-
dealers to disclose specific information to their customers about
securities transactions, including the price at which the transaction
was effected, remuneration such as sales charges paid by the customer
to the broker-dealer (if it is acting in an agency capacity), and in
certain circumstances remuneration received by the broker-dealer from
third parties such as a mutual fund or its affiliates.\217\ The
Commission and its staff have taken the position, with respect to
mutual fund transactions, that a broker-dealer may satisfy its rule
10b-10 obligations without providing customers with a transaction-
specific document that discloses information about sales charges or
third-party remuneration, so long as the customer receives a fund
prospectus that adequately discloses that information.\218\ Today, in
connection with the other amendments we are proposing to limit
cumulative sales charges and help investors make better choices when
selecting a fund that imposes sales charges, we are also proposing
amendments to rule 10b-10 to require disclosure of additional
information on transaction confirmations in connection with
transactions involving securities issued by mutual funds.\219\ In
addition, we are proposing to amend rule 10b-10 to require disclosures
related to callable debt securities, and to eliminate outdated
transition provisions.\220\
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\217\ 17 CFR 240.10b-10. Rule 10b-10 generally requires broker-
dealers that effect transactions for customers in securities, other
than U.S. savings bonds or municipal securities, which are covered
by Municipal Securities Rulemaking Board (``MSRB'') rule G-15 (which
applies to all municipal securities brokers and dealers) to provide
customers with written notification, at or before the completion of
each transaction, of certain basic transaction terms. This
transaction confirmation must disclose, among other information: The
date of the transaction; the identity, price and number of shares
bought or sold (see 17 CFR 240.10b-10(a)(1) (the confirmation must
also include either the time of the transaction or the fact that it
will be furnished upon written request)); the capacity of the
broker-dealer (see 17 CFR 240.10b-10(a)(2)); the net dollar price
and yield of a debt security (see 17 CFR 240.10b-10(a)(5) and (6));
and, under specified circumstances, the amount of compensation paid
by the customer to the broker-dealer, whether the broker-dealer is
receiving any other remuneration in connection with the transaction,
and whether the broker-dealer receives payment for order flow (see,
e.g., 17 CFR 240.10b-10(a)(2)(i)(B), (C), and (D)).
The rule's requirements, portions of which have been in effect
for over 60 years, provide basic investor protections by conveying
information that allows investors to verify the terms of their
transactions, alerts investors to potential conflicts of interest
with their broker-dealers, acts as a safeguard against fraud, and
provides investors a means to evaluate the costs of their
transactions and the execution quality. See Exchange Act Release No.
34962 (Nov. 10, 1994) [59 FR 59612, 59613 (Nov. 17, 1994)].
\218\ See Exchange Act Release No. 49148 (Jan. 29, 2004) [69 FR
6438 (Feb. 10, 2004)] at section IV.A.2. See also Investment Company
Institute, SEC Staff No-Action Letter (pub. avail. Apr. 18, 1979)
(``ICI Letter''). In this letter, the staff of the Commission's
Division of Market Regulation (now known as the Division of Trading
and Markets) stated that it would not recommend enforcement action
against broker-dealers that did not provide transaction-specific
disclosure about mutual fund loads and related charges, so long as
the customer received a prospectus that ``disclosed the precise
amount of the sales load or other charges or a formula that would
enable the customer to calculate the precise amount of those fees.''
This letter reflected a position that the Commission took when it
adopted rule 10b-10, when it articulated the view that, in the case
of registered securities offerings, separate confirmation disclosure
of third-party remuneration would be redundant if the customer
received a final prospectus disclosing that information. See
Exchange Act Release No. 13508 at n.41 (May 5, 1977) [42 FR 25318
(May 17, 1977)].
\219\ We proposed more comprehensive changes to the broker-
dealer confirmation requirements in 2004 through proposed Exchange
Act rule 15c2-2 as part of a broader initiative regarding
disclosures made to investors at the time an investment decision is
made. See Securities Exchange Act Release No. 49148, (Jan. 29, 2004)
[69 FR 6438 (Feb. 10, 2004)]. See also Securities Exchange Act
Release No. 51274 (Feb. 28, 2005) [70 FR 10521 (Mar. 1, 2005)]
(reopening of comment period). Proposed rule 15c2-2 would have
governed transactions in mutual funds, unit investment trust
(``UIT'') interests and 529 college savings plans, and in contrast
to rule 10b-10, would have prescribed a specific form to be used for
confirmation disclosure. The more targeted confirmation changes we
are proposing today, unlike our earlier proposal, involve amendments
to rule 10b-10 rather than a new confirmation rule and confirmation
form. This in part reflects comments we received on the rule 15c2-2
proposal, including commenters' concerns as to the cost of requiring
a separate confirmation rule and confirmation form for certain
securities. See, e.g., Comment Letter of Securities Industry
Association (Apr. 12, 2004) (File No. S7-06-04) (``brokerage firms
would have to bifurcate what is now a single stream of
confirmations, and create an entirely new stream of information for
mutual fund confirmations and a different stream for all other
securities transactions'').
\220\ See infra Section III.E.2 of this Release.
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1. Confirmation Disclosure of Sales Charges and Fees
We are proposing to amend rule 10b-10 to require confirmations to
set forth
[[Page 47083]]
information regarding front-end and deferred sales charges, as well as
ongoing sales charges and marketing and service fees (as defined in
proposed Investment Company Act rules 6c-10 and 12b-2) associated with
transactions involving mutual fund securities.\221\
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\221\ The term ``mutual fund security'' would be defined by
reference to the definition of ``open-end company'' in section
5(a)(1) of the Investment Company Act (15 U.S.C. 80a-5(a)(1)). While
exchange-traded funds are typically organized as open-end companies,
we understand that exchange-traded funds do not typically impose the
sales charges or other fees that would be subject to these
disclosure requirements.
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In making this proposal, we are mindful that while improving
confirmation disclosure of such fees can be expected to make the
confirmation a more complete record of the transaction and to promote
investor understanding of the fees, customers do not receive
confirmations until after completing their purchases of mutual funds;
accordingly, providing for improved disclosure of cost information
prior to the sale may be an additional step that we could consider to
help investors make better informed investment decisions.\222\
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\222\ In this regard, the staff is considering recommendations
for our future consideration to enhance the information provided at
the point of sale. We also note that Section 919 of the Dodd-Frank
Wall Street Reform and Consumer Protection Act states
``[n]otwithstanding any other provision of the securities laws, the
Commission may issue rules designating documents or information that
shall be provided by a broker or dealer to a retail investor before
the purchase of an investment product or service by the retail
investor.''
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Under the proposal, transaction confirmations for purchases of
those securities would disclose the amount of any sales charge that the
customer incurred at the time of purchase, in percentage and dollar
terms, along with the net dollar amount invested in the security and
the amount of any applicable breakpoint or similar threshold used to
calculate the sales charge.\223\ This information would be expected to
help make the confirmation a more complete record of the transaction
and promote investor understanding of associated costs, as well as
helping customers identify any errors associated with the front-end
sales charges they incur; inclusion of breakpoint information on the
confirmation particularly should assist investors in conveniently
identifying any breakpoint-related errors in the sales charges they
incurred.\224\
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\223\ See proposed new paragraph (a)(10)(i) of rule 10b-10. For
purposes of these rule 10b-10 amendments, the term ``sales charge''
is intended to be comparable to the term ``sales load,'' which the
Investment Company Act generally defines to mean the difference
between the public price of a security and the portion that is
invested (less deductions for certain fees). See section 2(a)(35) of
the Act.
\224\ See Report of the Joint NASD/Industry Task Force on
Breakpoints (July 2003) (``Breakpoint Report'') (http://www.finra.org/web/groups/industry/@ip/@issues/@bp/documents/industry/p006434.pdf) (``Confirmations should reflect the entire
percentage sales load charged to each front-end load mutual fund
purchase transaction. This information would enable investors to
verify that the proper charge was applied.'').
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Also, if the customer may pay a deferred sales charge upon
redemption of the shares (such as a contingent deferred sales charge),
a transaction confirmation provided to the customer at the time of
purchase would disclose the maximum amount of any deferred sales charge
that the customer may pay in the future.\225\ The amount would be
expressed as a percentage of the net asset value at the time of
purchase or at the time of redemption or sale, as applicable.\226\ This
proposed requirement is designed to provide a customer more complete
information about the deferred sales charge (which may serve as an
economic substitute for the front-end sales charge) that the customer
may be obligated to pay in the future.
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\225\ See proposed rule 10b-10(a)(10)(ii).
\226\ Id. A mutual fund could decide to calculate the deferred
sales load as the lower of the net asset value at the time of
purchase or at the time of redemption. Under rule 6c-10 under the
Investment Company Act, a deferred sales charge may not exceed ``a
specified percentage of the net asset value or the offering price at
the time of purchase.'' Rule 6c-10(a)(1).
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In addition, if, after the time of purchase, the customer will
incur any ongoing sales charge or marketing and service fee, purchase
confirmations would disclose the following information: The annual
amount of that charge or fee, expressed as a percentage of net asset
value; the aggregate amount of the ongoing sales charge that may be
incurred over time, expressed as a percentage of net asset value; and
the maximum number of months or years that the customer will incur the
ongoing sales charge. We anticipate that this disclosure could be made
relatively simply, for example: ``You will pay a maximum total ongoing
sales charge of 5%, deducted from the assets of the fund in which you
are investing at an annual rate of 1% over the next 5 years. You also
will pay marketing and service fees of 0.25% for as long as you own the
fund.'' \227\
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\227\ To the extent that the rate of the marketing and service
fee associated with a particular mutual fund were to increase or
decrease following the customer's purchase, rule 10b-10 would not
require the broker-dealer to provide an updated confirmation
statement to the customer. This information is typically disclosed
in a supplement to a fund's prospectus filed under rule 497 under
the Securities Act.
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Confirmations further would include the following statement (which
may be revised to reflect the particular charge or fee at issue): ``In
addition to ongoing sales charges and marketing and service fees, you
will also incur additional fees and expenses in connection with owning
this mutual fund, as set forth in the fee table in the mutual fund
prospectus; these typically will include management fees and other
expenses. Such fees and expenses are generally paid from the assets of
the mutual fund in which you are investing. Therefore, these costs are
indirectly paid by you.'' \228\ This proposal generally is intended to
help make transaction disclosure more complete by helping to ensure
that customers are informed about the use of ongoing sales charges that
serve as a substitute for front-end sales charges, as well as
additional uses of mutual fund assets to pay for distribution. The
statement about the presence of additional charges is intended to help
address the risk that confirmation disclosure of some ongoing charges
or fees may cause some customers to wrongly infer that those charges or
fees are all the ongoing costs that the customers would incur in
connection with owning a mutual fund security.\229\
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\228\ See proposed new paragraph (a)(10)(iii)(B) of rule 10b-10.
As discussed above, the term ``ongoing sales charge'' would be
defined in proposed rule 6c-10 under the Investment Company Act of
1940, 17 CFR 270.6c-10, and the term ``marketing and service fee''
would be defined in proposed rule 12b-2 under that Act, 17 CFR
270.12b-2.
\229\ We are not proposing to require that purchase
confirmations disclose management fees or other operating expenses,
as those costs are disclosed in the prospectus fee table and are not
directly implicated by the transaction. We also are not proposing to
specifically require that purchase confirmations disclose other
categories of compensation that the broker-dealer receives in
connection with the particular mutual fund being purchased, such as
``revenue sharing'' received from a fund's adviser.
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Finally, confirmations for transactions in which a customer redeems
or sells a mutual fund security the customer owns would disclose the
amount of any deferred sales charge the customer has incurred or will
incur, expressed in dollars and as a percentage of the net asset value
at the time of purchase or at the time of redemption or sale, as
applicable.\230\ This information also would be expected to help make
the confirmation a more complete record of the transaction and help
customers identify any errors.
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\230\ See proposed new paragraph (a)(11) of rule 10b-10.
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We are proposing corresponding changes to the alternative periodic
reporting provisions of rule 10b-10(b), which in part permit quarterly
reporting
[[Page 47084]]
for transactions involving investment company plans.\231\ As revised,
such periodic statements involving mutual fund security transactions
would include disclosure of sales charges consistent with the proposed
requirements for other confirmations.\232\
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\231\ See rule 10b-10(b) (permitting the disclosure of
transaction-related information in periodic account statements
rather than in confirmations for securities purchased or sold on a
periodic basis through ``investment company plans''); rule 10b-
10(d)(6) (defining ``investment company plan'' to include individual
retirement or pension plans and individual contractual arrangements
that provide for periodic purchases or redemptions of investment
company securities).
\232\ In particular, paragraph (b)(2) of rule 10b-10, as
revised, would require disclosure of ``any ongoing sales charges or
marketing and service fees incurred in connection with the purchase
or redemption of a mutual fund security.'' Consistent with the
proposed requirements of paragraphs (a)(10) and (a)(11), this would
encompass disclosure of front-end, deferred, and ongoing sales
charges.
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In sum, these proposed requirements are intended to help make the
confirmation a more complete record of the transaction, help investors
in mutual fund securities be more fully aware of the sales charges they
pay, and assist investors in verifying whether they paid the correct
sales charge set forth in the prospectus. In that regard, these
proposed requirements seek to take into account support that commenters
previously have expressed for improved confirmation disclosure of sales
charges, while also taking into account commenters' concerns regarding
the costs that would be associated with more extensive changes to
confirmation disclosure requirements.\233\ We understand that some
broker-dealers may already provide disclosures about front-end sales
charges in their mutual fund confirmations, in part in response to the
recommendations of the Joint NASD/Industry Task Force on
Breakpoints.\234\
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\233\ Investor advocates who commented on proposed rule 15c2-2
generally supported confirmation disclosure of costs. See Comment
Letter of the Consumer Federation of America, Fund Democracy,
Consumer Action, and the Consumers Union (Apr. 21, 2004) (File No.
S7-06-04) (``Confirmation and other post-sale disclosure should
quantify the costs incurred as a result of the transaction,
including any costs or payments that may have been estimated in pre-
sale disclosures.''). More generally, the Commission also received a
number of comments from the public that supported our proposals for
improving disclosure. See, e.g., Comment Letter of T. Booy (Mar. 16,
2004) (File No. S7-06-04); Comment Letter of R. Barndt (Mar. 15,
2004).
While securities-industry commenters generally opposed expanding
the scope of confirmation disclosures in other ways (and, as noted
above, stated that extensive changes to existing broker-dealer
confirmation systems would be particularly expensive), a number of
those commenters supported confirmation disclosure of front-end
sales charges, while not supporting confirmation disclosure of
ongoing costs of ownership. In the view of those commenters,
confirmations fundamentally are records of transactions that are
provided too late to assist investors in making decisions. See,
e.g., Commenter Letter of Securities Industry Association (Apr. 4,
2005) (File No. S7-06-04) (supporting confirmation disclosure of
sales charges in dollar and percentage terms, which would help
investors determine whether they received correct breakpoint
discounts; opposing confirmation disclosure of information about
ongoing fees and conflicts of interest as costly, repetitive and too
late to be useful); Comment Letter of Legg Mason Wood Walker Inc
(Apr. 4, 2005) (File No. S7-06-04) (opposing addition of items other
than sales charge information on confirmations as duplicative and as
providing information too late to be useful for investors; based on
their experience, investors look to the confirmation for information
about the date, amount and price of their mutual fund investments);
Comment Letter of Charles Schwab & Co., Inc. (Apr. 4, 2005) (File
No. S7-06-04) (supporting confirmation disclosure of transaction-
specific sales fees in dollar and percentage terms; opposing
disclosure on purchase confirmations of disclosure of contingent
deferred sales charges, and strongly opposing confirmation
disclosure of comprehensive annual costs and of conflict of interest
information).
\234\ See Breakpoint Report, supra note 224.
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In the event we adopt these amendments to provide for confirmation
disclosure of such sales charges, we intend to withdraw a no-action
letter that the Commission's staff issued to the Investment Company
Institute in 1979, related to confirmation disclosure of mutual fund
sales loads and related fees, as that letter would no longer be
consistent with the rule.\235\
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\235\ See ICI Letter, supra note 218; see also Breakpoint
Report, supra note 224 (``In connection with this recommendation,
the Task Force also recommends that the SEC staff revisit its April
18, 1979 No-Action Letter, which permits the omission of sales
charge information from confirmations.'')
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We request comment on all aspects of these proposals, including the
following:
Would the information we propose to include in transaction
confirmations be useful to investors? Would confirmation disclosure of
quantified information about ongoing sales charges and marketing and
service fees, without quantified information of other ongoing costs
associated with owning mutual funds, imply that no other ongoing fees
would be associated with their purchase? Would it imply that other
ongoing fees are smaller or otherwise less important? If so, should
confirmations also set forth the percentage amount of other ongoing
expenses, including, but not limited to: (a) Other shareholder fees, as
disclosed in the mutual fund prospectus fee table pursuant to Item 3 of
Form N-1A; (b) management fees, as disclosed in the mutual fund
prospectus fee table pursuant to Item 3 of Form N-1A; and (c) any other
expenses, disclosed in the mutual fund prospectus fee table pursuant to
Item 3 of Form N-1A?
Conversely, given that marketing and service fees (unlike
ongoing sales charges) would not act as economic substitutes for front-
end sales charges, should we amend rule 10b-10 to require disclosure of
quantified information about marketing and service fees? Could
requiring confirmation disclosure of marketing and service fees lead to
disparate disclosure to the extent that mutual funds follow disparate
practices with regard to whether they use the proceeds of marketing and
service fees to pay for certain types of services?
Would the statement set forth in proposed rule 10b-
10(a)(10)(iii)(B) be sufficient to put investors on notice that they
will be subject to additional costs over and above the disclosed front-
end, deferred and ongoing charges and fees? Alternatively, should such
ongoing fees be disclosed in some document other than the transaction
confirmation? For example, would the account statement required by
self-regulatory organization (``SRO'') rules \236\ be a more
appropriate document for disclosures of ongoing costs, or for
information about the source and amount of broker-dealer remuneration
in connection with the mutual fund?
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\236\ See NASD Conduct Rule 2340 (Customer Account Statements).
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Would it be helpful to investors to require disclosure of
front-end and deferred sales charges in dollar terms? Would limiting
the disclosure to percentage terms be a cost-effective way of
permitting customers to check the terms of the transaction? Would it be
helpful to investors to require that confirmations for mutual fund
purchase transactions set forth the maximum amount of any deferred
sales charge that the customer may incur upon redeeming the mutual
fund? \237\
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\237\ FINRA rules currently require broker-dealers to include
the following disclosure in transaction confirmations for investment
company purchases: ``On selling your shares, you may pay a sales
charge. For the charge and other fees, see the prospectus.'' See
NASD Conduct Rule 2830(n).
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Should rule 10b-10 also specify the format and
presentation of how such cost and fee information should be disclosed
(e.g., specifically requiring that such information be highlighted on
the confirmation, or placed in the front of a confirmation if a paper-
based confirmation is used, or be subject to a minimum font size)?
Should transaction confirmations--or some other document--
seek to quantify the total amount of front-end, ongoing and deferred
fees the specific investor may expect to incur over time under
reasonable assumptions; if so, how could such an ``all in'' fee be
presented most effectively?
Should purchase confirmations for mutual funds also be
specifically
[[Page 47085]]
required to set forth quantified information about the source and
amount of all remuneration that the broker-dealer directly or
indirectly receives in connection with the mutual fund, including, for
example, ``revenue sharing'' received from a fund's adviser?
In addition, we request comment on whether the proposed
disclosures should be applicable to transactions in other securities
that may carry sales charges, such as UIT interests, real estate
investment trust interests or direct participation plan interests.
Commenters particularly are asked to address any disclosure issues that
are particular to each of those products; UIT interests, for example,
may carry a combination of initial sales charges, deferred sales
charges (deducted in periodic installments) and so-called ``creation
and development'' fees. To the extent these amendments are applicable
to UIT interests, would special provisions be needed to address
transactions involving variable insurance products?
We further request comment on whether the proposed
requirement for disclosure of front-end sales charges also should
require disclosure of equivalent costs (i.e., the difference between
the public price and the resulting amount invested) incurred in
connection with purchases made during primary offerings of closed-end
funds. In addition, we request comment on whether the confirmation
requirements of rule 10b-10 should be revised to encompass transactions
in 529 college savings plan interests, which, as municipal securities,
currently are excluded from the application of rule 10b-10.
2. Additional Changes to the Confirmation Rule
In addition to proposing confirmation rule changes in connection
with our proposed replacement of rule 12b-1 with a new regulatory
scheme, we are also proposing to amend rule 10b-10 to require
disclosure of the first date on which certain debt securities may be
called.\238\ Disclosure of the first date upon which a debt security
may be called will provide customers with meaningful information that
is intended to help avoid any confusion for investors who are not
otherwise aware that a bond may be called on a date earlier than the
one specified on the confirmation. In particular, the rule as revised
would require disclosure of the first date on which the security may be
called when a broker-dealer effects a transaction in a debt security on
the basis of yield-to-call.\239\ Currently, the rule requires a broker-
dealer that had effected a transaction in a debt security on the basis
of yield-to-call to disclose, among other information, the type of
call, the call date, and the call price. A bond may be subject to call
on a series of dates; as a result, although a confirmation may have
stated what the bond's yield-to-call would be if the bond is called on
one of those dates, the confirmation may not have informed a customer
about the first possible date on which a bond is subject to call. That
may confuse investors who are not otherwise aware that a bond may be
called on a date earlier than the one specified on the confirmation.
The possibility of earlier call can subject the investor to additional
reinvestment risk, because the investor may have worse alternatives for
reinvesting the proceeds if the issuer calls the security when
prevailing interest rates decline.
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\238\ This proposal is consistent with proposed amendments to
rule 10b-10 that we made in 2004 in conjunction with proposed rule
15c2-12. See note 219, supra. We received no comments on this aspect
of the proposal. At that time, we also proposed to amend rule 10b-10
to require broker-dealers that effect transactions in callable
preferred stock to disclose to their customers that the stock may be
repurchased at the election of the issuer and that additional
information is available upon request. We are not reproposing that
amendment at this time, but will continue to consider the need for
such a requirement.
\239\ See proposed paragraph (a)(6)(i) of rule 10b-10.
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We request comment on whether this proposal would provide
useful information to investors.
Finally, we propose to delete paragraph (e)(2) of rule 10b-10,
which sets forth transitional provisions related to confirmation
requirements for security futures products, and which expired in
2003.\240\
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\240\ Consistent with that deletion, we also propose to
redesignate paragraphs (e)(1)(i) through (e)(1)(iv) as paragraphs
(e)(1) through (e)(4).
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We request comment on this technical amendment.
F. Shareholder Approval
Marketing and Service Fee. Under proposed new rule 12b-2, a fund
would be required to obtain the approval of a majority of its
shareholders before it could institute, or increase the rate of, a
marketing and service fee.\241\ However, shareholder approval would not
be required for a fund to institute a marketing and service fee with
respect to a new class of fund shares, allowing a fund to institute (or
increase) a marketing and service fee and apply it only to investments
in the new class and avoid the cost of soliciting proxies to obtain
shareholder approval.\242\
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\241\ See proposed rule 12b-2(b)(2).
\242\ Under the proposed rule, shareholder approval would only
be necessary with respect to the class or series affected by the fee
increase.
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An existing shareholder in a share class that institutes a
marketing and service fee may have invested in reliance on disclosure
that the fund does not charge such fees or charges them at a lower
rate. In order to avoid paying new marketing and service fees, the
shareholder's only recourse would be to redeem his shares and risk
incurring significant additional costs, including potential capital
gains taxes. Less vigilant investors may only discover new marketing
and service fees after paying them for some time. Thus, we believe that
these charges should not be imposed or increased without shareholder
approval.\243\
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\243\ See section 1(b)(1) of the Act, which provides, in
relevant part, that ``the national public interest and the interest
of investors are adversely affected--(1) when investors purchase * *
* securities issued by investment companies without adequate,
accurate, and explicit information, fairly presented, concerning the
character of such securities. * * *''
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For similar reasons, rule 12b-1 currently requires shareholder
approval when a 12b-1 plan is adopted or is amended to increase
materially the amount to be spent for distribution,\244\ and thus in
this regard our proposal would not significantly change the rights of
fund shareholders or the obligations of funds and fund underwriters.
Fund directors would not (as discussed above) be specifically required
by the rule to approve the fees, although fund directors may determine
to solicit proxies in support of (or in opposition to) the imposition
of the fee or an increase in the fee.
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\244\ Rules 12b-1(b)(1) and (b)(4).
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Ongoing Sales Charge. Ongoing sales charges would be treated
differently, however. Under the proposed amendments to rule 6c-10, a
fund would not be permitted to institute, or increase the rate of, an
ongoing sales charge, or lengthen the period before shares
automatically convert to another class of shares that does not incur an
ongoing sales charge, 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.\245\ A new fund (i.e., a fund that has not made a public
offering), or an existing fund with respect to a new class of shares,
would not need to obtain shareholder approval before instituting a
marketing and service fee or an ongoing sales charge (because no
shareholders that are not affiliated with the fund's sponsor
[[Page 47086]]
would be affected).\246\ However, after the fund or class has been sold
to the public, an ongoing sales charge would not be permitted to be
instituted or raised with regard to that fund or class.
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\245\ See proposed rule 6c-10(b)(3).
\246\ Similar to rule 12b-1, a fund would not be required to
obtain shareholder approval for marketing and service fees or
ongoing sales charges that are implemented prior to the sale of fund
shares to the public. Rule 12b-1(b)(1). See also supra note 41.
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We believe that ongoing sales charges should not be instituted or
increased in existing funds, or lengthened in duration, regardless of
shareholder approval. The current regulatory framework does not allow
for sales charges to be retroactively imposed or increased with regard
to prior investments, and we believe that permitting increases in
ongoing sales charges in existing share classes would negatively impact
investors. Shareholders may select a fund in part based on the level of
the ongoing sales charge, if any, and the level of services they
received from the intermediary receiving the ongoing sales charge.
Under the proposed rules, an institution or increase of an ongoing
sales charge after a shareholder has agreed to pay a defined cumulative
ongoing sales charge would be akin to retroactively renegotiating the
terms of the contract without the explicit consent of the particular
shareholder affected.
We request comment on the shareholder approval requirements.
Should we require shareholder approval to institute or
increase a marketing and service fee? Would permitting funds to
institute, increase, or lengthen the period of ongoing sales charges
negatively impact investors? Should we permit shareholder approval to
institute, or increase the rate of, an ongoing sales charge, or
lengthen the period before shares automatically convert to another
class of shares that does not incur an ongoing sales charge? Should the
rule specify who should bear the cost of soliciting shareholder proxies
to approve or increase the rate of an asset-based distribution fee? If
so, should the fund or the fund underwriter bear the cost?
G. Application to Funds of Funds
We propose provisions in both rules 12b-2 and 6c-10 that would
address asset-based distribution fees that could be deducted when one
fund (the ``acquiring fund'') invests in shares of another (the
``acquired fund''). Section 12(d)(1)(A) of the Act, our rules, and the
NASD sales charge rule currently include provisions that restrict the
layering of sales loads, asset-based sales charges and service fees in
so called fund of funds arrangements, in which one investment company
invests in the shares of another.\247\ As described further below, we
would include similar provisions to restrict the layering of marketing
and service fees and ongoing sales charges in the amendments we are
today proposing.
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\247\ Section 12(d)(1)(A) of the Act prohibits a registered
investment company (and any investment companies it controls) from:
(i) Acquiring more than 3 percent of the outstanding voting
securities of any other investment company; (ii) investing more than
5 percent of its total assets in any one acquired investment
company; or (iii) investing more than 10 percent of its total assets
in all acquired investment companies. Section 12(d)(1)(B) prohibits
a registered open-end investment company (i.e. an acquired fund)
from: selling securities to any acquiring investment company if,
after the sale the acquiring investment company (together with
investment companies it controls) would (i) own more than 3 percent
of the acquired fund's outstanding voting securities or (ii)
together with other acquiring investment companies (and investment
companies they control) own more than 10 percent of the acquired
fund's outstanding voting securities. Section 12(d)(1)(F) of the Act
provides an exemption from the limitations of section 12(d)(1) that
allows a registered investment company to invest all its assets in
other investment companies if, among other things, the sales load
charged on the acquiring investment company's shares is no greater
than 1.5 percent. Rule 12d1-3 allows acquiring investment companies
relying on section 12(d)(1)(F) to charge sales loads greater than
1.5 percent provided that the sales charges and service fees charged
with respect to the acquiring investment company's securities do not
exceed the limits of the NASD sales charge rule applicable to funds
of funds. Rule 12d1-3(a). The NASD sales charge rule requires funds
of funds to aggregate sales charges and services fees paid by both
the acquiring and acquired funds in complying with its limits. See
NASD Conduct Rule 2830(d)(3).
Section 12(d)(1)(G) provides a similar exemption that permits a
registered open-end fund or UIT to acquire an unlimited amount of
shares of registered open-end funds and UITs that are part of the
same ``group of investment companies'' as the acquiring fund. The
provision is available only if either: (i) The acquiring fund does
not pay (and is not assessed) sales loads or distribution related
fees on securities of the acquired fund (unless the acquiring fund
does not itself charge sales loads or distribution related fees); or
(ii) the aggregate sales loads or distribution related fees charged
by the acquiring fund on its securities, when aggregated with any
sales load and distribution related fees paid by the acquiring fund
on acquired fund securities, are not excessive under rules adopted
under section 22(b) or 22(c) of the Act by a securities association
registered under section 15A of the Exchange Act, or the Commission.
The NASD has adopted limits on sales loads and distribution related
fees applicable to funds as well as to funds of funds. See NASD
Conduct Rule 2830. See also Section II.C.1 of this Release.
Under the NASD sales charge rule's provision for funds of funds,
if neither the acquiring nor acquired investment company has an
asset-based sales charge (12b-1 fee), the maximum aggregate sales
load that can be charged on sales of acquiring investment company
and acquired investment company shares cannot exceed 8.5 percent (or
7.25 percent if the company pays a service fee). See NASD Sales
Charge Rule 2830(d)(3)(A). Any acquiring or acquired investment
company that has an asset-based sales charge must individually
comply with the sales charge limitations on investment companies
with an asset-based sales charge, provided, among other conditions,
that if both companies have an asset-based sales charge, the maximum
aggregate asset-based sales charge cannot exceed 75 basis points per
year of the average annual net assets of both companies; and the
maximum aggregate sales load may not exceed 7.25 percent of the
amount invested (or 6.25 percent if either company pays a service
fee). See NASD Conduct Rule 2830(d)(3)(B). The rule is designed so
that cumulative charges for sales related expenses, no matter how
they are imposed, are subject to equivalent limitations. See 1992
NASD Rule Release, supra note 66, at text accompanying n.9. See also
NASD Notice to Members 99-103 (Dec. 1999) (http://www.finra.org/RulesRegulation/NoticestoMembers/1999NoticestoMembers/P004026) (``We
have amended the [sales charge rule] to ensure that, if both levels
of funds in a fund of funds structure impose sales charges, the
combined sales charges do not exceed the maximum percentage limits
currently contained in the rule.'').
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1. Marketing and Service Fee
Proposed rule 12b-2 would permit both an acquiring fund and an
acquired fund in a fund of funds arrangement to charge a marketing and
service fee, as long as the total of the fees charged by the funds
together does not exceed the NASD service fee limit (25 basis
points).\248\ Thus, under proposed rule 12b-2(b)(2), if an acquiring
fund deducts a marketing and service fee of 10 basis points, it would
be limited to investing in other funds that deduct a marketing and
service fee of no more than 15 basis points. This is the same approach
as that taken by the NASD sales charge rule, which limits a fund of
funds to a combined service fee of 25 basis points, and which limits a
fund of funds that wishes to hold itself out as a no-load fund to
combined service fees and asset-based sales charges (12b-1 fees) of 25
basis points.\249\
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\248\ Proposed rule 12b-2(b)(2).
\249\ NASD Conduct Rule 2830(d)(3)(C).
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We request comment on our approach to applying rule 12b-2 to fund
of funds arrangements.
Should we, instead, preclude either acquiring funds or
acquired funds from charging a marketing and service fee rather than
cumulating the amounts? In the case of an acquiring fund investing in
multiple acquired funds charging different marketing and service fee
rates, should the rule's limits apply to the weighted average of the
marketing and service fees rather than the maximum fee? \250\ Would
this be feasible? If so, how often should the acquiring fund determine
such a weighted average for purposes of complying with the limits on
marketing and service fees in proposed rule 12b-2? What other methods
could be used to ensure that
[[Page 47087]]
shareholders in funds of funds do not pay excessive fees under proposed
rule 12b-2?
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\250\ See proposed rule 12b-2(b)(2). We understand that the NASD
sales charge rule's limits on cumulative service fees and asset-
based sales charges (for no-load funds) does not permit weighted
averaging, and thus applies the maximum rate as would our proposed
rule. See NASD Conduct Rule 2830(d)(3).
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2. Ongoing Sales Charges
We are also proposing that an acquiring fund and an acquired fund
could not both charge an ongoing sales charge. Under proposed rule 6c-
10(b)(1)(iv), an acquiring fund that relies on the rule to deduct an
ongoing sales charge could not acquire the securities of another fund
that imposed an ongoing sales charge.\251\ An acquiring fund that did
not charge an ongoing sales charge would not be subject to this
restriction and would therefore be free to invest in funds imposing an
ongoing sales charge.
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\251\ An acquiring fund would determine its ongoing sales charge
as the amount it deducts from fund assets in excess of its marketing
and service fee, without regard to any acquired fund's marketing and
service fee. Proposed rule 6c-10(d)(11).
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We understand that the classes of shares of most acquired funds do
not carry 12b-1 fees or, if they do, carry a 12b-1 fee of less than 25
basis points. We also understand that when funds do acquire shares of
other funds with a sales load or 12b-1 fee, they often do not charge
loads or 12b-1 fees themselves.\252\ Thus, if our proposal were
adopted, we do not expect that it would affect the structure or
operation of most funds of funds.
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\252\ See, e.g., New Century Portfolios, Prospectus at 18
(http://www.newcenturyportfolios.com/Documents/Prospectus%203.01.09%20-%20New%20Century%20Portfolios%20Final.pdf)
(acquiring funds do not charge a sales load, and 12b-1 fees for the
five series range from 0.10% to 0.22%).
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We request comment on our understanding, and how our
proposal would affect funds of funds.
Our approach to applying proposed rule 6c-10(b) to funds of funds
is not the same as the approach taken by the NASD sales charge rule,
which permits asset-based sales charges at both levels but requires the
rates to be accumulated in determining compliance with the relevant
limits.\253\ We have not taken this approach because it would involve
substantial complexities when an acquiring fund invests in (and over
time purchases and sells) multiple acquired funds (with different
ongoing sales charges) that would have to be factored into the length
of conversion periods that would be required by proposed rule 6c-10(b).
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\253\ NASD Rule 2830(d)(3)(B)(ii).
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We request comment on this proposed approach. We request
that commenters who favor an approach that would require accumulating
of ongoing sales charges (rather than restricting ongoing sales charges
on either the acquiring or acquired fund), address how accumulation
might work in a way that is not unduly complicated.
H. Application to Funds Underlying Separate Accounts
Our proposed rule and rule amendments would apply to funds that
serve as investment vehicles for insurance company separate accounts
that offer variable annuities or life insurance contracts.\254\
Separate accounts are typically organized as unit investment
trusts.\255\ They invest the proceeds of premium payments made by
contract owners in one or more mutual funds (underlying funds) that
manage the assets that support the insurance contracts.
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\254\ See section 2(a)(37) of the Act (defining ``separate
account'').
\255\ See section (4)(2) of the Act (defining ``unit investment
trust''). See, e.g., Wendell M. Faria, Variable Annuities & Variable
Life Ins. Reg. Sec. 3:4.2 (Dec. 2009) (``[P]ractically all separate
accounts are organized as unit investment trusts under a two-tier
structure in which the separate account invests in an affiliated or
unaffiliated underlying fund (or funds) organized as an open-end
management investment company.'').
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Owners of variable insurance contracts may pay substantial
distribution costs \256\ in the form of a front-end load, a contingent
deferred load, or ongoing charges that are deducted from the assets
held by the separate account, or a combination of these charges.\257\
In addition, directors of some underlying funds have approved adoption
of rule 12b-1 plans to support various distribution and shareholder
servicing activities.\258\ We understand that in most cases these
charges do not exceed 25 basis points annually.
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\256\ The FINRA sales charge rules do not place a maximum sales
charge limitation on variable contracts. See NASD Notice to Members
99-103; Order Granting Approval of and Notice of Filing and Order
Granting Accelerated Approval of Amendments Nos. 4, 5, and 6 to the
Proposed Rule Change Relating to Sales Charges and Prospectus
Disclosure for Mutual Funds and Variable Contracts, Exchange Act
Release No. 42043 (Oct. 20, 1999) [64 FR 58112 (Oct. 28, 1999)]
(approving NASD rule change eliminating maximum sales charge
limitations on variable contracts). Until 1996, section 27 of the
Act effectively limited the amount of the sales load that could be
charged on a variable contract. When Congress enacted the National
Securities Market Improvement Act of 1996, it amended section 27 to
provide an exemption for variable contracts. Public Law 104-290
(1996).
\257\ See Goldberg and Bressler, supra note 52, at n.28 (``While
variable insurance products, like mutual funds, did not pay
distribution fees prior to the adoption of rule 12b-1, they paid
mortality and expense charges. These provided a source of revenue to
reimburse the insurance company for the portion of the sales
commission not covered by a CDSL.'').
\258\ See Comment Letter of Sutherland, Asbill & Brennan, on
behalf of the Committee of Annuity Insurers (July 19, 2007) (similar
to traditional mutual funds, underlying funds charge 12b-1 fees to
support activities such as promoting underlying funds to prospective
contract owners, printing underlying fund prospectuses, and training
and educating agents).
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Under our proposed rule changes, underlying funds would be treated
like other mutual funds. Thus, an underlying fund could charge a
marketing and service fee up to the NASD sales charge rule limit on
service fees. Asset-based distribution fees in excess of the marketing
and service fee would be deemed ongoing sales charges and subject to
the requirements of the proposed amendments to rule 6c-10. Like other
mutual funds, in order to impose an ongoing sales charge under proposed
rule 6c-10(b), an underlying fund (or the insurance company sponsor)
would have to keep track of share lots attributable to contract owner
purchase payments, and provide for the automatic conversion of shares
by the end of the conversion period. We understand that insurance
company separate accounts may not currently track and age shares
because they generally do not offer underlying funds with contingent
deferred sales loads. Under our proposal, insurance companies would
either have to develop this capability or offer only shares of classes
that do not impose an ongoing sales charge.\259\
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\259\ We discuss this issue as it arises in the context of
retirement plans in Section III.M.5 of this Release, infra. We
discuss the potential costs of implementing a conversion feature in
Section IV of this Release, infra.
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We request comment on whether we should treat underlying funds
differently than other funds.
Given that most distribution activities occur at the
separate account-level, is it appropriate to permit underlying funds to
impose the marketing and service fee or ongoing sales charges? \260\
How would these fees be used? Should we limit underlying funds to the
marketing and service fee? Should we consider some other structure for
limiting fees charged by underlying funds?
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\260\ See, e.g., Comment Letter of JoNell Hermanson (July 9,
2007) (urging elimination of 12b-1 fees for variable products
because ``12b-1 fees have become a `shell game' for insurance
companies and have allowed them to camouflage their profit margin as
investment management fees.'').
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I. Proposed Amendments to Rule 6c-10: Account-Level Sales Charge
We are also proposing to amend rule 6c-10 to provide funds with an
alternative approach to distributing fund shares through dealers if the
fund so chooses.\261\ Under the proposed
[[Page 47088]]
elective provision, a fund (or a class of the fund) could issue shares
at net asset value (i.e., without a sales load) and dealers could
impose their own sales charges based on their own schedules and in
light of the value investors place on the dealer's services. In effect,
this exemption would allow the unbundling of the sales charge
components of distribution from the price of fund shares, similar to
the existing ETF distribution model. The proposed rule amendment is,
among other things, designed to provide flexibility to fund
underwriters and dealers, encourage price competition among dealers
offering mutual funds and, ultimately, benefit fund investors.
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\261\ Proposed rule 6c-10(c).
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1. Section 22(d): Retail Price Maintenance
Section 22(d) of the Investment Company Act prohibits mutual funds,
their principal underwriters, and dealers from selling mutual fund
shares to the public except at a current public offering price as
described in their prospectus. Because mutual fund sales loads are part
of the selling price of the shares,\262\ this provision essentially
fixes the price at which mutual fund shares may be sold because all
dealers in a fund's shares must sell shares at the same sales load
disclosed in the prospectus.\263\ By requiring that all dealers sell
shares of a particular fund to the public only at uniform prices as
established by the fund, section 22(d) effectively prohibits
competition in sales loads on mutual fund shares at the retail
level.\264\
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\262\ See also section 2(a)(35) of the Act (defining ``sales
load'' to mean ``the difference between the price of a security to
the public and that portion of the proceeds from its sale which is
received and invested or held for investment by the issuer (or in
the case of a unit investment trust, by the depositor or trustee),
less any portion of such difference deducted for trustee's or
custodian's fees, insurance premiums, issue taxes, or administrative
expenses or fees which are not properly chargeable to sales or
promotional activities'').
\263\ See Exemption from Section 22(d) to Permit the Sale of
Redeemable Securities at Prices that Reflect Different Sales Loads,
Investment Company Act Release No. 13183 (Apr. 22, 1983) [48 FR
19887 (May 3, 1983)] (``Rule 22d-1 Proposing Release'') (``This
section effectively prohibits price competition in sales loads on
mutual fund shares at the retail level.'').
\264\ By its terms, section 22(d) only applies to principal
underwriters and dealers in fund shares and does not apply to
brokers. See United States v. National Ass'n of Sec. Dealers, Inc.,
422 U.S. 694, 715 (1975). The securities laws draw a distinction
between dealers and brokers. Generally, a dealer buys and sells
securities for its own account as part of a regular business; a
broker acts as an agent by matching buy and sell orders between
other investors. The same intermediary may act as either a broker or
a dealer, depending upon the transaction. See 15 U.S.C. 78a-3(a)(4),
(a)(5); 15 U.S.C. 80a-2(a)(6), (a)(11). Although section 22(d) only
applies to principal underwriters and dealers in fund shares, funds
also are able to maintain control over their distribution networks
through share transfer restrictions permitted under section 22(f) of
the Act. See National Ass'n of Sec. Dealers, Inc., 422 U.S. at 729.
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Our rules have provided limited exemptions from this provision, for
example, by permitting funds to establish ``scheduled variations'' in
sales loads that allow for volume discounts, although the amount and
terms of these discounts must be uniform and set forth in their
prospectuses.\265\ Section 22(d) continues, however, to preclude
dealers from competing with each other by establishing their own
pricing schedules or negotiating different terms with their customers.
Dealers may offer their customers a choice of alternate funds with
differing sales loads; they may not, however, offer discounts on sales
loads established by the funds whose shares they sell.
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\265\ See rule 22d-1; Exemption from Section 22(d) to Permit the
Sale of Redeemable Securities at Prices that Reflect Different Sales
Loads, Investment Company Act Release No. 14390 (Feb. 22, 1985) [50
FR 7909 (Feb. 27, 1985)]. We have also provided an exemption from
section 22(d) for certain insurance company separate accounts, and
in other circumstances. See, e.g., rule 22d-2 under the Act.
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In enacting section 22(d) as part of the original Act in 1940,
Congress gave funds authority to control their distribution to a degree
denied most commercial enterprises by the federal antitrust laws.\266\
The reasons Congress might have had to achieve such a result are
unclear, due to the paucity of legislative history or other clear
indications about Congress's intent when it adopted the provision.\267\
Section 22(d) has been the subject of considerable debate because it
tends to restrict rather than foster competition. Some, including
roundtable participants and commenters, have identified section 22(d)
as inhibiting competition and contributing to high distribution
charges.\268\
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\266\ See the Sherman and Clayton Acts, 15 U.S.C. 1-7; 15 U.S.C.
12-27; 29 U.S.C. 52, 53. Although such restrictions on price
competition would normally be a violation of the antitrust laws,
section 22(d) provides antitrust immunity for such restrictions. See
National Ass'n of Sec. Dealers, Inc., 422 U.S. at 701 (``* * * Sec.
22(d) of the Investment Company Act requires broker-dealers to
maintain a uniform price in sales in this primary market to all
purchasers except the fund, its underwriter, and other dealers. And
in view of this express requirement, no question exists that
antitrust immunity must be afforded these sales.'').
\267\ See, e.g., Rule 22d-1 Proposing Release, supra note 263
(``[T]here is relatively little in the Act's legislative history to
explain the purpose of section 22(d) * * *.'').
\268\ See, e.g., Comment Letter of the Consumer Federation of
America, et al., (May 10, 2004) (File No. S7-09-04) (``The reality,
however, is that while competition flourishes, that competition does
not necessarily serve to benefit investors. In fact, in the broker-
sold portion of the market, funds compete to be sold, not bought.
When funds compete to be bought, they compete by offering a good
product and good service at a reasonable price. When funds compete
to be sold, they do so by offering generous financial incentives to
the sales force. Far from benefiting investors, this reverse
competition tends to drive costs up, not down, and it allows
mediocre high-cost funds to survive, and even thrive. The primary
reason investors are being denied the benefits of competition is the
legal requirement that funds set the compensation that brokers are
paid for the services that those brokers provide to the
investor.''); Roundtable Transcript, supra note 109, at 103 (Thomas
Selman, FINRA) (``One [area in need of revisiting] is 22(d), the
retail price maintenance provision in the `40 Act, which, for
example, prohibits a broker-dealer from simply charging its own
commission for the sale of a fund at NAV, like they would a stock.
There is no reason, really, why that restriction still should be in
place.'').
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Commenters have suggested a number of rationales for the enactment
of section 22(d), including: (i) Eliminating certain ``riskless''
trading practices by fund insiders; (ii) preserving an orderly
distribution of mutual fund shares; and (iii) protecting shareholders
from price discrimination.\269\ Regulatory and marketplace developments
that have occurred since 1940, however, have addressed the rationales
that have been attributed to section 22(d). The Commission addressed
the harms of riskless trading abuse in 1968 when it adopted rule 22c-1,
which requires the ``forward pricing'' of mutual fund shares.\270\ The
Supreme Court also found in 1975 that section 22(f) of the Act permits
funds to manage any secondary market in fund shares and preserve an
orderly distribution system.\271\ Finally, as we noted in 1983 in
connection with a rule proposal under section 22(d), the concern of
unjust price discrimination among purchasers has been substantially
dispelled by the results achieved from the unfixing of brokerage
commission rates in 1975 after our adoption of rule 19b-3 under the
Securities Exchange Act of 1934.\272\ That rule prohibits
[[Page 47089]]
national securities exchanges from requiring members to charge fixed
brokerage commissions, and market experience after the rule showed that
commission rates fell into rational patterns that reflect the sales
costs involved and the services provided.\273\
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\269\ See Rule 22d-1 Proposing Release, supra note 263 at text
accompanying nn.5-8.
\270\ See id., at section 1.b; Adoption of Rule 22c-1 under the
Investment Company Act of 1940 Prescribing the Time of Pricing
Redeemable Securities for Distribution, Redemption, and Repurchase,
and Amendment of Rule 17a-3(a)(7) under the Securities Exchange Act
of 1934 Requiring Dealers to Time-Stamp Orders, Investment Company
Act Release No. 5519 (Oct. 16, 1968) [33 FR 16331 (Nov. 7, 1968)].
Rule 22c-1 requires that mutual fund purchases and redemptions be
executed at the price next computed after receipt of the order. See
rule 22c-1(a). The execution of transactions at prices previously
computed (which had been permitted in the past) thus would violate
rule 22c-1, in addition to other applicable provisions such as anti-
fraud provisions. See, e.g., In the Matter of Charles Schwab & Co.,
Inc., Investment Company Act Release No. 26595 (Sept. 14, 2004)
(settlement of a case where a broker-dealer permitted certain
favored clients to submit ``substitute'' mutual fund trades past the
4 pm fund pricing deadline).
\271\ See United States v. National Ass'n of Sec. Dealers, Inc.,
422 U.S. 694 (1975).
\272\ See Rule 22d-1 Proposing Release, supra note 263, at
section 1.b of Discussion.
\273\ See id.; Charles M. Jones & Paul J. Seguin, Transaction
Costs and Price Volatility: Evidence from Commission Deregulation,
87 Amer. Econ. Rev. 728, 730 (1997) (``Evidence from Commission
Deregulation'').
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As discussed in detail below, we are proposing an elective account-
level sales charge alternative that would exempt certain funds from the
requirements of section 22(d). We are proposing this account-level
sales charge alternative pursuant to section 6(c) of the Act, which
provides broad authority for the Commission to exempt any class of
persons, securities, or transactions from the Act to the extent that
such an exemption is ``necessary or appropriate in the public interest
and consistent with the protection of investors and the purposes fairly
intended by the policy and provisions of this title.'' \274\ For the
reasons discussed in this section and below, we anticipate that this
proposed approach would expand the range of distribution models
available to mutual funds, enhance transparency of costs to investors,
promote greater price competition, and provide a new alternative means
for investors to purchase fund shares at potentially lower costs. Thus,
we believe that the account-level sales charge approach we are
proposing today would be necessary and appropriate in the public
interest, and is consistent with the protection of investors and the
purposes fairly intended by the policy and provisions of the Act.
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\274\ 15 U.S.C 80a-6(c). In addition to the authority granted us
by section 6(c), section 22(d)(iii) of the Act provides an exception
from retail price maintenance for sales made ``in accordance with
rules and regulations of the Commission made pursuant to subsection
(b) of section 12.'' We are also proposing the account-level sales
charge alternative pursuant to our authority in section 22(d)(iii),
although for ease of reference we have included the proposed
provision in rule 6c-10.
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2. Account-Level Sales Charges
Proposed rule 6c-10(c) would permit a fund in certain circumstances
to offer its shares or a class of its shares at a price other than the
current public offering price stated in the prospectus. A fund class
could offer shares to dealers who would then be free to establish and
collect their own commissions or other types of sales charges to pay
for distribution. The amount of these fees (and the times at which they
would be collected) would not be governed by the Act.\275\ Thus, for
example, this fee could be paid directly by the investor or could be
charged to the investor's brokerage account, depending on the
arrangement between the intermediary and investor. The intermediary
could charge this fee at the time of sale, over time, or upon
redemption.
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\275\ Intermediaries registered with FINRA would continue to be
subject to existing limits on excessive compensation under NASD
Conduct Rules 2830 and 2440.
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This type of sales load arrangement would be similar to the
``externalized sales charge'' concept on which we requested comment in
2004,\276\ and which was discussed extensively at our 2007 12b-1
roundtable.\277\ In light of the many concerns raised by commenters, we
are not proposing to require funds to externalize their distribution
expenses.\278\ Rather, we propose to make this available as an option
for funds that so elect. The commissions or fees charged by the dealers
to their customers could be determined in the same manner as
commissions and fees charged on other types of financial products.\279\
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\276\ See 2004 Rule 12b-1 Amendments Proposing Release, supra
note 107. In particular, we asked comment on one approach of
refashioning rule 12b-1 to provide that funds deduct distribution
related costs directly from shareholder accounts rather than from
fund assets. We received over 1700 comment letters in response to
the release's request for comment, many of which presented
alternatives and suggestions that warranted additional review. We
deferred proposing any further changes at that time. See 2004 Rule
12b-1 Amendments Adopting Release, supra note 106, at section II.C.
\277\ See, e.g., Roundtable Transcript, supra note 109, at 103
(Thomas Selman, FINRA), 157, 165 (John Hill, Putnam Funds), 204-07
(Richard Phillips, K&L Gates), and 207-13 (Avi Nachmany, Strategic
Insight; Barbara Roper, Consumer Federation of America).
\278\ Among other issues, commenters were concerned that
requiring all funds to externalize their distribution systems would
result in high transition costs, significant disruptions to current
distribution systems, higher distribution costs for small investors,
and adverse tax consequences. See, e.g., Comment Letter of the ICI
(May 10, 2004) (File No. S7-09-04); Comment Letter of the Financial
Planning Association (May 10, 2004) (File No. S7-09-04). See also
Roundtable Transcript, supra note 109, at 207-209 (Avi Nachmany,
Strategic Insight). But see id. at 207 (Richard Phillips, K&L
Gates). Some commenters objected to our requiring externalized
distribution fees because they assumed that externalization would
force shareholders to liquidate fund shares to pay the fees, which
would cause investors to realize capital gains (or losses). See,
e.g., Comment Letter of Terry Curnes (May 3, 2004) (File No. S7-09-
04); Comment Letter of Legg Mason, Inc. (May 10, 2004) (File No. S7-
09-04). In most cases, however, intermediary-sold funds are held in
accounts that have alternative sources of cash to pay distribution
fees, e.g., interests in a money market fund, the use of which would
not result in adverse tax consequences to investors. See Egon
Guttman, 28 Modern Securities Transfers Sec. 4:15 (3d ed. 2009).
\279\ The antitrust immunity provided by section 22(d) for the
fund's other distribution channels, if any, would not be disturbed
by this proposed exemption. See, e.g., Rule 22d-1 Proposing Release,
supra note 263 (``Since the proposed rule would exempt investment
companies, principal underwriters, and dealers only to the extent
and under such conditions as determined by the Commission to be
consistent with the protection of investors, in the Commission's
view, existing antitrust immunity afforded by section 22(d) would
not be affected by the proposed rule.'').
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We believe this alternative approach to distribution may be
attractive to dealers, funds, and fund shareholders. Dealers offering
an array of funds from different fund groups could sell each fund to
their customers according to a single price schedule, which could take
into consideration the volume of transactions with that dealer (rather
than the size of the purchase of shares of the particular fund), the
level and type of services provided, and the type of fund offered.
Currently, investors pay the same costs for distribution when
purchasing a fund, regardless of the quality or type of services
provided by a dealer. Under our proposal, if the dealer and the fund
elect to permit it, investors would be able to choose the level of
dealer services they want and pay only for their chosen services.
Investors might, for example, choose low-cost, low-service plans; high-
cost, high-service plans; or something in between that better matches
their preferences.
Such an approach could also simplify the operations of the dealer,
which could process transactions based on a single, uniform fee
structure. Such a structure could eliminate or reduce the need to
educate employees (e.g., broker-dealer representatives) on the myriad
distribution arrangements offered in today's market, and help avoid
mistakes that may harm customers and expose the dealer to liability
when employees make errors.\280\ And it could eliminate (or at least
ameliorate) dealer conflicts
[[Page 47090]]
that may lead them (or their employees) to recommend funds to customers
based on the amount of the compensation received from selling the
funds, rather than on the customer's needs.\281\
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\280\ On occasion, the complexity and variety of sales load
arrangements has contributed to the failure of some intermediaries
to provide their customers with the breakpoints to which they were
entitled. Report of the Joint NASD/Industry Task Force on
Breakpoints at 7 (July 2003) (http://www.finra.org/web/groups/rules_regs/documents/rules_regs/p006434.pdf) (``Thus, a broker-
dealer that sells funds offered by multiple mutual fund families
must understand the aggregation opportunities offered by each fund
family in order to deliver all appropriate breakpoint discounts to
its customers. As broker-dealers increase the number of fund
families whose funds they offer, fulfilling the obligation to
understand the aggregation opportunities becomes an increasingly
complex and burdensome task.''). Another example of the difficulties
that can arise from a multiplicity of differing fund policies and
fees was brought to our attention when a number of intermediaries
commenting on the redemption fee rule supported a uniform redemption
fee as a means of eliminating the complexity associated with these
fees. See Rule 22c-2 Adopting Release, supra note 103, at text
following n.93.
\281\ See, e.g., Report of the Committee on Compensation
Practices at 7 (Apr. 10, 1995) (http://www.sec.gov/news/studies/bkrcomp.txt) (``Some product sales or transactions offer much higher
commission payouts to [registered representatives] than others.
$10,000 invested in the typical front-end `load' stock mutual fund,
for instance, produces over twice as much immediate commission
revenue to the registered representative as an equal amount invested
in exchange-listed stocks.''). See also Ruth Simon, Why Good Brokers
Sell Bad Funds, Money, July 1991 (http://money.cnn.com/magazines/moneymag/moneymag_archive/1991/07/01/86657/index.htm).
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An externalized fee structure may appeal to some fund groups as
well, including small funds and new entrants to the market that are
eager to attract dealers that wish to sell shares based on their own
fee schedules. Funds that choose to sell their shares only through an
externalized fee structure could significantly simplify their
operations and shorten their prospectuses by eliminating the need for
multiple classes of shares.
Fund investors may benefit from buying funds through dealers that
entered into these distribution arrangements in several ways. By
reducing conflicts for dealers, these arrangements would reduce the
risk that investors would be placed in funds that are not suitable for
their particular circumstances. Sales charges would be more transparent
and could be imposed or deducted in a manner and at a time that is most
attractive to the investor.\282\ Investors may be able to negotiate
lower loads with their dealers by, for example, forgoing some of the
services that they would otherwise pay for with the distribution
charges, or by engaging in a substantial amount of business with the
dealer (although not necessarily with the particular fund or fund
family). Moreover, externalized fee structures may permit investors to
invest in dealer-sold funds without purchasing associated (and
unwanted) services. If negotiable account-level sales charges are
accepted by market participants, increased competition among dealers
may result in lower overall distribution costs or more attractive
services for investors.\283\
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\282\ Some participants in our roundtable identified
disadvantageous tax consequences as a reason for retaining asset-
based sales charges rather than externalized sales charges. See,
e.g., Roundtable Transcript, supra note 109, 208-09 (Avi Nachmany,
Strategic Insight). Under the proposed approach, however, investors
purchasing through intermediaries could select a method of payment
that would yield the best after-tax result for them.
\283\ See Comment Letter of Bridgeway Funds, Inc., and Bridgeway
Capital Management (July 19, 2007); see also Hannah Glover, Schwab
Slashes ETF Expenses in Challenge to Vanguard, BlackRock, Ignites
(June 15, 2010) (noting that ETF distribution model, which similarly
permits the unbundling of the sales charge components of
distribution from fund shares, has seen steady decreases in fees and
commissions).
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Externalized fee arrangements are currently used in a number of
other contexts and thus appear to be operationally feasible. For
example, separately managed accounts and wrap accounts operate on an
externalized distribution model.\284\ In each case, at least part of
the distribution costs is paid out of the assets of the account. As
discussed above, recent years have seen the growing predominance of
wrap accounts and other arrangements that entail separate fees paid by
investors to intermediaries.\285\ Some of the roundtable participants
expressed concern that current externalized fee arrangements in other
contexts (e.g. separately managed accounts and wrap accounts) tended to
have higher rather than lower fees than mutual funds and thus may be
disadvantageous to smaller investors.\286\
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\284\ See, e.g., Roundtable Transcript, supra note 109, at 76-78
(Martin Byrne, Merrill Lynch).
\285\ See supra text preceding notes 97 and 98.
\286\ See, e.g., Roundtable Transcript, supra note 109. at 207-
13 (Avi Nachmany, Strategic Insight; Barbara Roper, Consumer
Federation of America). See also Comment Letter of the ICI (July 19,
2007); Comment Letter of Gary Roth (June 13, 2007); Comment Letter
of Rick Sany (June 13, 2007). But see Comment Letter of Mark
Freeland (June 19, 2007) (``But why should a mutual fund wrap
account cost more if it is only providing the same level of service?
Moreover, if the levels of service are indeed different, couldn't
advisers create another tier of service for a lower fee, much as
mutual fund wrap accounts typically charge less than equity wrap
accounts?'').
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Should this be of concern to us as we consider this
rulemaking? Are those higher charges related to additional services and
features that these products and accounts provide, and therefore not
comparable to the externalized sales charge alternative we are
proposing?
We request comment on the advantages and disadvantages of allowing
an externalized alternative distribution model.
Would fund investors benefit from this distribution model?
If so, how would they benefit or otherwise be affected? Are there
significant drawbacks to investors to permitting this distribution
model and, if so, what are they? What competitive or anti-competitive
effects could result from such a model? Would our proposed alternative
distribution model allow investors to effectively choose among dealers
for the right balance of price and service when buying mutual funds?
How else might the availability of this distribution model affect
investor behavior? We are interested in hearing from retirement plan
administrators and trustees whether this distribution alternative might
offer the beneficiaries of the plans increased transparency.
We request comment on whether the availability of a class
of fund shares that does not carry fixed distribution charges would
increase competition among dealers and lead to lower sales charges for
investors. Since 1975, when we abolished fixed brokerage commission
rates, the cost of brokerage has decreased significantly for both
institutional and retail brokerage customers.\287\ Could we expect a
similar result for fund investors if we permit retail price competition
for at least some classes of shares of mutual funds?
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\287\ See, e.g., Evidence from Commission Deregulation, supra
note 273.
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How would other market participants react to our proposed
exemption? Would fund managers take advantage of this distribution
model? Would competition among funds for the interest of dealers induce
fund managers to offer a class of shares permitting dealers to control
distribution pricing? Would discount broker-dealers begin offering
funds that had previously been sold only through ``full-service''
brokers? Would ``full-service'' broker-dealers begin offering a class
of the same shares at lower cost to their customers who, for example,
bought and sold funds without the assistance of their representatives?
Would dealers view our proposed exemption as providing an alternative
that would help them reduce complexities and conflicts in selling fund
shares? Would the exemption help reduce conflicts of interest by
permitting dealers to eliminate differences in compensation and thus
encouraging recommendations based solely on the best interests of their
customers? If many funds rely on the proposed rule, what would be the
effects on distribution arrangements, and on distributors that do not
rely upon the rule?
3. Account-Level Sales Charges: Terms of Proposed Rule 6c-10(c)
The account-level sales charge alternative would be available to
any fund with respect to all of its shares, or any class of its
shares.\288\ As we discussed above, the exemption is optional, and
funds may choose not to take advantage of it and continue to distribute
their shares only with sales charges established by the fund.
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\288\ Proposed rule 6c-10(c).
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In order for a fund to rely on the section 22(d) exemption provided
in proposed rule 6c-10(c), it would have to
[[Page 47091]]
meet two conditions. First, the fund (with respect to that share class)
would not be permitted to impose an ongoing sales charge as defined in
proposed amendments to rule 6c-10.\289\ We are proposing the account-
level sales charge as an alternative to an ongoing sales charge rather
than as a supplement to it. The fund could, however, charge a marketing
and service fee pursuant to proposed rule 12b-2.\290\ Second, the fund
would have to disclose in its registration statement that it has
elected to rely on the exemption, which would allow interested
investors the ability to better understand the distribution structure
of the fund.\291\ A fund relying on proposed rule 6c-10(c) would be
permitted to use the marketing and service fee to support the fund's
marketing and sales efforts, including advertising, sales material, and
call centers, while permitting dealers to collect loads, fees, and
other account-based charges to support the dealers' sales assistance
and other services provided to its customers.
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\289\ Proposed rule 6c-10(c)(1).
\290\ See proposed rule 12b-2(b).
\291\ See proposed rule 6c-10(c)(2). The disclosure would appear
in the fund's Statement of Additional Information (``SAI''). See
proposed Item 25(d) of Form N-1A.
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We request comment on all aspects of proposed rule 6c-10(c).
Should we require that each fund class charge a marketing
and service fee in order to rely on proposed rule 6c-10(c), or should a
fund instead be able to offer a class of its shares in reliance on rule
6c-10(c) without charging such a fee? Alternatively, as we have
proposed, should proposed rule 6c-10(c) be available to all funds,
regardless of whether they use fund assets to finance distribution
pursuant to proposed rule 12b-2? We also request comment on the
condition that the fund class not deduct an ongoing sales charge
pursuant to proposed rule 6c-10(b). Are there any circumstances under
which a fund should be permitted to rely on the exemption under
proposed rule 6c-10(b) and charge an ongoing sales charge under
proposed rule 6c-10(c)?
We request specific comment on whether the fund's election
to rely on proposed rule 6c-10(c) should be disclosed anywhere other
than the registration statement. We also request comment on where the
fund's election should appear in the registration statement. As
proposed, the election would be disclosed in the fund's Statement of
Additional Information.\292\ Should it appear in the fund's prospectus
or summary prospectus? Should the fund's board be required to make or
specifically approve the election?
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\292\ Proposed Item 25(d) of Form N-1A.
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Are any other conditions appropriate? Should we limit the
exemption to funds that sell their shares to dealers at net asset
value? Are there any additional benefits or problems associated with
proposed rule 6c-10(c)?
We also request comment on the interaction between
proposed rule 6c-10(c) and the other amendments we are proposing in
this Release. For example, if the Commission does not adopt proposed
rule 12b-2, proposed rule 6c-10(b) or the proposed rescission of rule
12b-1, should it nevertheless adopt proposed rule 6c-10(c)? Is any of
the rationale that supports the Commission's adoption of rule 6c-10(c)
diminished (or augmented) if the Commission does not adopt any of the
other amendments it is today proposing?
J. Amendments To Improve Disclosure to Investors
We are proposing several amendments to our disclosure requirements
to improve the transparency of sales loads and asset-based distribution
fees. The amendments, which reflect the new approach we are proposing
with respect to asset-based distribution fees, are designed to improve
investors' understanding of the distribution related charges they would
directly and indirectly incur as a result of investing in a fund.
1. Amendments to Form N-1A
Form N-1A is the registration form used by funds to register with
the Commission under the Securities Act and the Investment Company Act.
Item 3 of Form N-1A sets forth the requirements for the prospectus
``fee table,'' which lists all fund expenses.\293\ Rule 12b-1 fees
currently are disclosed as a fund operating expense under the heading
``Distribution [and/or Service] (12b-1) Fees.'' \294\
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\293\ We recently amended Form N-1A to require key information
to appear in plain English in a standardized order in mutual fund
prospectuses, including information about the fund's investment
objectives and strategies, risks, costs, and performance. In the
same release, we also amended rule 498 under the Securities Act to
allow a fund to satisfy its prospectus delivery obligations under
section 5(b)(2) of the Securities Act by providing the summary
prospectus, if the full statutory prospectus is available on an
Internet Web site. See Enhanced Disclosure and New Prospectus for
Registered Open-End Management Investment Companies, Investment
Company Act Release No. 28584 (Jan. 13, 2009) [74 FR 4546 (Jan. 26,
2009)] (``Summary Prospectus Adopting Release''). In the proposing
release for the summary prospectus, we requested comment as to
whether we should consider other revisions to the headings in the
fee table to make them more understandable to investors, including
eliminating the term 12b-1. See Enhanced Disclosure and New
Prospectus Delivery Option for Registered Open-End Management
Investment Companies, Investment Company Act Release No. 28064 (Nov.
21, 2007) [72 FR 67790 (Nov. 30, 2007)] (``Summary Prospectus
Proposing Release''). However, in the Summary Prospectus Adopting
Release, we concluded that it was more appropriate to consider these
changes in the context of a full reconsideration of sales charges
and rule 12b-1. See Summary Prospectus Adopting Release at text
accompanying n.126.
\294\ See Item 3 of Form N-1A.
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The reference in the current fee table to ``12b-1 fees'' is not, of
course, consistent with the new regulatory approach we are proposing
for asset-based distribution fees. Moreover, the current fee table may
not present the fee most effectively. Many of our roundtable panelists,
as well as a number of commenters on our summary prospectus rule,
agreed that reference to an SEC rule number is not informative.\295\
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\295\ See, e.g., Roundtable Transcript, supra note 109, at 106
(Bob Uek, MFS Funds). See also Comment Letter of The Honorable
Donald Manzullo (Feb. 28, 2006) (File No. S7-28-07) (``In keeping
with the idea of simplified disclosures, a preferential way to begin
would be by re-naming the fees altogether, as the name `12b-1' is
esoteric, at best.'').
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To address these concerns, we are proposing to amend the fee table
requirements to separate asset-based distribution fees into two
component fees. Specifically, we propose to delete the current heading,
and replace it with the heading ``Ongoing Sales Charge,'' which would
be the ongoing sales charge we are proposing today. This line item
would continue to appear in the lower portion of the fee table which
relates to the expenses that shareholders pay indirectly as a result of
holding an investment in the fund, expressed as a percentage of net
asset value.\296\ We would also add a new subheading to the ``Other
Expenses'' category called ``Marketing and Service Fee.'' \297\ Funds
would include each of these line items in their fee tables only if they
charge the relevant fee.\298\
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\296\ The percentage of the maximum front-end and deferred sales
loads would continue to be presented in the upper part of the fee
table related to fees that are paid directly by shareholders upon
entry to or exit from the fund.
\297\ The fee table currently requires funds to disclose
separately only two types of operating expenses--management fees
(the fee paid to the investment adviser) and 12b-1 fees. The rest of
a fund's operating expenses are included under the caption ``other
expenses.'' The instructions permit funds to subdivide this caption
into no more than three sub-captions that identify the largest
expense or expenses comprising ``other expenses,'' but the fund must
include a total of all ``other expenses.'' See Instruction 3(c) to
Item 3 of Form N-1A.
\298\ Instruction 1(c) to Item 3 of Form N-1A.
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The new heading and subheading correspond to our treatment of these
charges under the new rule and rule
[[Page 47092]]
amendments we are proposing today,\299\ and are designed to more
clearly describe the fees to investors.\300\ In particular, the
``Ongoing Sales Charge'' heading should better convey to investors that
this portion of the asset-based distribution fee operates as a
substitute for a sales load. When this heading is used in a prospectus
offering multiple classes with adjacent fee tables, investors may be
more likely to understand the nature of the alternatives available to
them. We view greater investor understanding of this fee as an
important goal of this rulemaking, and expect that it would lead to
more informed decisions by investors when selecting among funds and
fund share classes.
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\299\ See supra Sections III.C and III.D of this Release.
\300\ A recent opinion issued by the Second Circuit emphasizes
the importance of accurate description and categorization of fund
fees to investors. The court noted that the full and accurate
description of both the amount and use of fees charged by a fund is
an important part of the ``total mix'' of information in an
investor's decision to purchase shares. See Operating Local 649 v.
Smith Barney Fund Management LLC, 595 F.3d 86 (2d Cir. 2010) (``Few
facts would likely constitute more important ingredients in
investors' `total mix' of information than the fact that, in
violation of these disclosure requirements the expenses categorized
as transfer agent fees were not transfer agent fees at all * * *.
The importance of the accurate reporting of categories of fees in
prospectuses is obvious: A ``comparative'' fee table is not useful
to an investor if the information in the table is incomplete or
otherwise misleading * * *.'').
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Today, some funds may pay for certain services (e.g., sub-
accounting fees to a retirement plan administrator) in the form of a
``rule 12b-1 fee,'' while others pay for the same service as an
ordinary fund operating expense and account for the expense as ``other
expenses'' in the operating expenses portion of the current fee
table.\301\ Similarly, under our proposed approach, some funds are
likely to treat expenses for the same service as a ``marketing and
service fee'' or ``other expenses.'' Different approaches to the same
fees do not affect the comparability of fund expense ratios, but will
affect the subcategories of the fee table. Because of the various uses
and purposes of the charges that may be included as marketing and
service fees under our proposal, we believe disclosure of this fee
would fit best as a subheading to the ``other expenses'' category. We
believe that it is important for investors to know whether a fund
charges a marketing and service fee, but do not believe it requires its
own heading in the fee table.
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\301\ See Item 3 of Form N-1A.
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We request comment on the proposed location for the marketing and
service fee disclosure in the fee table.
Does including the marketing and service fee in the
``other expenses'' category raise any concerns that it may obscure the
fact that all or a portion of the marketing and service fee is or may
be used for distribution purposes? If so, would it matter to most
investors?
We request comment on the two headings and the names that
we have proposed for them.\302\ Would they help investors better
understand the nature of the fees? Are there better names we could use?
Should we require the disclosure of additional categories of fees?
Should we require that additional fee information be provided in the
fee table? For example, should the fee table indicate fees paid
initially, annually, and upon redemption? Should we also require that
the conversion period for the ongoing sales charge be included in the
fee table (or a footnote to the table), to provide investors with an
immediate reference for how long the fee would be charged?
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\302\ The Commission has long sought to find a descriptive term
that both informs investors and accurately describes the fees
deducted pursuant to a 12b-1 plan. In 1988, when we began requiring
funds to disclose certain fee information in the form of a uniform
fee table, fees deducted pursuant to a 12b-1 plan were simply listed
as an annual operating expense called ``12b-1 Fees.'' Consolidated
Disclosure of Mutual Fund Expenses, Investment Company Act Release
No. 16244 (Feb. 1, 1988) [53 FR 3192 (Feb. 4, 1988)]. This
description of 12b-1 expenses was criticized as being uninformative,
and in 1998 we made a number of amendments to Form N-1A, including
renaming the ``12b-1 Fee'' heading as ``Distribution [and/or
Service] (12b-1) Fees.'' Registration Form Used by Open-End
Management Investment Companies, Investment Company Act Release No.
23064, at text accompanying n.79 (Mar. 13 1998) [63 FR 13916 (Mar.
23, 1998)]. Similar to the approach we are proposing today, the
hypothetical illustrative example that was a part of our summary
prospectus proposal used separate headings (Distribution Fee and
Service Fee) in the fee table. See Summary Prospectus Proposing
Release, supra note 293.
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We also request comment on our proposed use of the term
``marketing and service fee.'' Is it too general a term to provide
useful disclosure to investors? We are proposing this term instead of
only the term ``service fee'' because funds could use the marketing and
service fee for different activities than the ``service fee'' defined
by the NASD, and because we are concerned that use of only the term
``service fee'' in some circumstances could mislead investors.\303\
Should we permit funds that do not use the fees for distribution
related purposes to use the term ``service fee'' in lieu of ``marketing
and service fee''? Would such an alternative diminish the comparability
of fund fee tables and thus their usefulness to investors in comparing
expenses among different funds? Would a different term, such as ``sales
and service fee'' or ``distribution and service fee'' be more
descriptive or informative to investors? \304\
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\303\ See supra note 100 and accompanying text.
\304\ See supra text following note 161.
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Finally, we request comment on fee table disclosure of
asset-based distribution fees charged under existing 12b-1 plans, as
permitted by proposed rule 12b-2(d).\305\ Should Item 3 continue to
require disclosure of ``12b-1 fees'' that are charged in the future?
\306\ Alternatively, should the 12b-1 fees be disclosed as marketing
and service fees and ongoing sales charges, as appropriate? Should
another term be used?
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\305\ See infra Section III.N.3 (treatment of ``grandfathered''
shares).
\306\ See Item 3 of Form N-1A (requiring disclosure of
``Distribution [and/or Service] 12b-1 Fees'').
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We also propose to amend Item 12(b) of Form N-1A, which currently
requires funds that have adopted 12b-1 plans to disclose information
about the operation of the plan in the prospectus.\307\ Because funds
would no longer be required to have a ``plan,'' we are proposing to
eliminate this requirement. Instead, we would require funds to disclose
whether they charge a marketing and service fee or an ongoing sales
charge and, if they do, to disclose the rates of the fees and the
purposes for which they are used.\308\ In addition, if the fund deducts
an asset-based distribution fee for services provided to fund
investors, it would need to describe the nature and extent of the
services provided.\309\ We would also require a fund that imposes an
ongoing sales charge to disclose the number of months (or years) when
the shares will automatically convert (to another class without the
charge) and after which the shareholder would cease paying the
charge.\310\
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\307\ This disclosure complements the information presented in
tabular form in the fee table.
\308\ Proposed Item 12(b) of Form N-1A.
\309\ Id.
\310\ For funds that choose the account-level sales charge
alternative, existing regulatory provisions would generally require
the delivery of similar information to investors in their
confirmation statements. See rule 10b-10 under the Exchange Act [17
CFR 240.10b-10].
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We would also require a fund offering multiple classes of shares in
a single prospectus (each with its own method of paying distribution
expenses) to describe generally the circumstances under which an
investment in one class may be more advantageous than another
class.\311\ We understand investors often face difficulties when
deciding which share class they should purchase because the advantages
and disadvantages of each class are not
[[Page 47093]]
always clearly presented in the prospectus.\312\ Although the differing
fees and terms of each class currently are readily available, the
actual consequences of the decision to purchase a particular class (in
terms of overall loads paid, appropriate holding periods, etc.) may not
be readily apparent. We believe that requiring funds to provide a clear
description of the situations in which one class may be more
advantageous than another would reduce shareholder confusion and
simplify the investment decision making process, and we understand that
some funds currently provide this type of disclosure.
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\311\ Proposed Item 12(b)(2) to Form N-1A.
\312\ FINRA has addressed, on numerous occasions, the
responsibilities of its members in helping investors understand and
evaluate the sales structures of different classes of funds. See,
e.g., Special Notice to Members 95-80 (Sept. 1995) (http://finra.complinet.com/finra/display/display_content.html?rbid=1189&element_id=1159003637). See also FINRA,
Understanding Mutual Fund Classes (Jan. 14, 2003) (http://www.finra.org/Investors/protectyourself/InvestorAlerts/MutualFunds/p006022).
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We request comment on these proposed amendments to Item 12(b).
Would the disclosure be useful to investors in identifying
the appropriate class to purchase? Should we provide more specific
disclosure requirements? If so, what should they be? Would funds have
difficulties in providing this information?
We are also proposing to amend Item 19(g) of Form N-1A, which
currently requires a fund to describe in detail the material aspects of
its 12b-1 plans and related agreements, in the Statement of Additional
Information (SAI). Under our proposals, funds would no longer be
required to have written ``plans'' that are approved by the board of
directors, and thus much of this item would no longer serve any
purpose. We therefore propose to eliminate paragraphs 2 through 6 of
Item 19(g).\313\ Because these items relate to the specific operation
of a 12b-1 plan that would no longer be required under our proposal, we
believe that they should be removed.
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\313\ Item 19(g)(2) requires a fund to disclose the relationship
between the amounts paid to the distributor under a 12b-1 plan and
the expenses it incurs. Item 19(g)(3) requires disclosure of any
unreimbursed expenses incurred by the plan and carried over to
future years. Item 19(g)(4) requires disclosure of any joint
distribution activities with another fund and the method of
allocating distribution costs (any joint arrangement between funds
that implicates section 17(d) and rule 17d-1 would require the funds
to apply for and obtain an exemption from the Commission prior to
implementing the arrangement). Item 19(g)(5) requires disclosure of
whether any interested person or director has a financial interest
in the operation of the 12b-1 plan. Item 19(g)(6) requires
disclosure of the anticipated benefits of the plan to the fund.
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We request comment as to whether we should retain any of
these parts of Item 19(g).
We believe that some of the other information required to be
disclosed under Item 19(g) may continue to be useful to investors and
the Commission. In particular, Item 19(g)(1) which includes a list of
the principal activities paid for under the plan and the dollar amounts
spent on each activity over the last year as a material aspect of a
12b-1 plan, may help investors to more clearly understand how the
asset-based distribution fees they pay are used. We propose to amend
Item 19(g) to eliminate references to the 12b-1 plan, and instead
require disclosure of the principal activities paid for through asset-
based distribution fees (both ongoing sales charges and marketing and
service fees). As proposed, the amendment would not require disclosure
of dollar amounts.\314\
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\314\ We do not believe that disclosure of the actual dollar
amount spent on these activities would be useful to investors
because that figure would depend primarily on the size of the fund,
and not the services purchased.
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We request comment on the proposed amendments to Item 19(g).
Specifically, we request comment whether we should retain
the disclosures required by Item 19(g)(1) as it currently exists,
including the dollar amounts spent on each activity. Our proposal would
remove this disclosure because we believe that the information is
unlikely to be important to investors. Should these disclosure
requirements be eliminated or retained? Should we require funds to
disclose the percentage of fees spent on each type of activity instead?
Are there any other activities that are not disclosed in Item 19(g)
that should be disclosed under our proposal?
Finally, we propose to: (i) Amend Item 25 of Form N-1A to add a
paragraph (d) requiring funds electing to rely on the exemption to
section 22(d) of the Act provided by rule 6c-10(c) to state that the
fund has made this election; and (ii) eliminate existing Item 28(m) of
Form N-1A, which requires a registered fund to attach its rule 12b-1
plan and any related agreements as an exhibit to its registration
statement. The exhibit would be unnecessary because proposed rule 12b-2
would not require a written plan, and funds that charge grandfathered
fees would not be required to have a written plan.\315\
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\315\ See infra Section III.N.3 for a discussion of
grandfathering funds and share classes. We also are proposing
additional conforming, technical changes to other items of Form N-
1A, including: Instruction 3(b) to Item 3; Item 26(b)(4); and Item
27(d)(1) (and Instruction 2(a)(i) to Item 27(d)(1)). These changes
are necessary to delete references to rule 12b-1 and rule 12b-1
plans and add references to rules 12b-2(b) and (d) and to 6c-10(b)
as the operative rules regarding asset-based distribution fees.
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We request comment on these proposed changes to Item 25
and Item 28(m) of Form N-1A.
2. Amendments to Schedule 14A
Our proposal would require funds to obtain shareholder approval
before instituting or increasing the rate of marketing and service fees
deducted from fund assets in existing share classes.\316\ To obtain
shareholder approval, funds generally have to solicit proxies from
their shareholders, and those proxy solicitations must include
sufficient information to allow shareholders to make an informed
decision. Item 22(d) of Schedule 14A under the Exchange Act \317\
requires funds to disclose information regarding any distribution plan
adopted under rule 12b-1 and the fees paid under the plan when
soliciting proxy votes for approval of any material change in that
plan. This disclosure is designed to provide shareholders with relevant
information regarding the distribution costs of the fund when they are
voting on issues that impact their investment.\318\ Our proposal would
eliminate the need for a distribution plan as currently required by
rule 12b-1, which would make much of the disclosure required in Item
22(d) of Schedule 14A no longer relevant. Therefore, we propose to
amend Item 22(d) of Schedule 14A, as well as replace the term
``distribution plan'' used in Schedule 14A with the new defined term
``Marketing and Service Fee.'' \319\
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\316\ Generally, as allowed by rule 12b-1 (and as our proposal
would allow), most funds institute a marketing and service fee or an
ongoing sales charge before a fund is offered for sale to the
public. See rule 12b-1(b)(1); Section III.F of this Release. If a
fund wishes to institute a new marketing and service fee after a
public offering, or increase those fees, the fund would be required
to disclose in the proxy the information discussed in this section
of the Release. As discussed in Section III.F, funds may not
increase or impose an ongoing sales charge in a share class of a
fund 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.
\317\ 17 CFR 240.14a-101.
\318\ See Amendments to Proxy Rules for Registered Investment
Companies, Investment Company Act Release No. 19957 (Dec. 16, 1993)
[58 FR 67720 (Dec. 22, 1993)] at section II.F.
\319\ Proposed Item 22(a)(iii) of Schedule 14A would define
``Marketing and Service Fee'' to mean ``a fee deducted from Fund
assets to finance distribution activities pursuant to rule 12b-
2(b).''
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Although our proposal would not require a distribution plan, it
would permit funds to continue to use fund assets for distribution
related purposes. In addition, it would require fund shareholders to
approve any institution of, or increase in the rate of, marketing
[[Page 47094]]
and service fees charged by the fund.\320\ In order for fund
shareholders to make appropriate and informed decisions, we believe
that shareholders would continue to find information regarding the rate
of marketing and service fees, the purposes of the fees, the reasons
for any proposed increase, and the identity of certain affiliated
recipients relevant to their voting decisions. Thus, we propose to
leave these disclosures, which are currently required under Item 22(d),
substantially unchanged.\321\
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\320\ See proposed rule 12b-2(b)(2).
\321\ See Item 22(d)(1)-(3) of Schedule 14A; proposed Item
22(d)(1), (2) of Schedule 14A.
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Because our proposal would not require any special action by the
board of directors in approving marketing and service fees, we do not
believe that information regarding the board of directors'
consideration of these fees would be relevant to the shareholder voting
decision. Therefore, we propose to eliminate the disclosure
requirements in Item 22(d) regarding director involvement in approving
asset-based distribution fees.\322\
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\322\ See Item 22(d)(4) of Schedule 14A.
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We also propose to eliminate the current requirement that funds
disclose in Item 22(d) the aggregate dollar amount of distribution fees
paid by the fund in the previous year. When we initially discussed such
disclosure in 1979, we envisioned that the disclosure of aggregate
dollar amounts could be useful for shareholders who were being asked to
renew a 12b-1 plan.\323\ This information may have been useful for
shareholders who were evaluating whether the expenditure of dollar
amounts was helpful to address certain problems or circumstances that
the 12b-1 plan addressed. In light of our current proposal to eliminate
12b-1 plans, however, and the fact that the aggregate dollar amount of
marketing and service fees primarily reflects the rate of the fee and
the size of the fund (information that is readily available elsewhere),
we believe this information is unlikely to affect a shareholder's
decision to approve an increase in a marketing and service fee. Thus,
we propose to eliminate the requirement to disclose information
regarding asset-based distribution fees in Item 22(d).\324\
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\323\ See 1979 Proposing Release, supra note 33, at text
accompanying n.37 (``If shareholders were being asked to vote on the
renewal of a plan, it would appear appropriate to include as well
the amount spent by the fund in the previous fiscal year, as a total
dollar amount and as a percentage of average net assets during that
period, and the benefits to the fund from such expenditures.'').
\324\ See Item 22(d)(2)(iii) of Schedule 14A. This information
will continue to be available to investors in the financial
statements that are included in annual and semi-annual shareholder
reports. See Item 27 of Form N-1A (requiring the inclusion of
financial statements required by Regulation S-X); 17 CFR 210.6-07
(Regulation S-X requirement that the statement of operations
separately state management and service fees); proposed amendment to
17 CFR 210.6-07 (proposed requirement that Regulation S-X require
the separate statement of ``all fees deducted from fund assets to
finance distribution activities'' pursuant to rules 12b-2(b), (d) or
6c-10(b) under the Investment Company Act). In addition, directors
will continue to review the amounts charged to funds in the course
of their oversight of fund expenses.
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We request comment on our proposed changes to Schedule 14A.
Should we require disclosure of any other aspects of
marketing and service fees in the proxy statement? Is information about
the aggregate amount of marketing and service fees collected relevant
and meaningful to investors? Should we include any requirement for
disclosure of director involvement in the setting of marketing and
service fees?
3. Request for Comment on Account Statement Alternative
The GAO previously suggested that the Commission consider requiring
funds to disclose in account statements the actual dollar amount of
fees and expenses that each shareholder directly or indirectly has paid
as an investor in the fund.\325\ Many commenters argued, however, that
such an approach would be unduly costly and may not be helpful to
shareholders.\326\ We believe that our proposed amendments would
improve transparency of distribution related expenses without requiring
funds and intermediaries to incur the costs that these commenters have
asserted are associated with account statement disclosures.\327\
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\325\ See GAO, Mutual Fund Fees: Additional Disclosure Could
Encourage Price Competition, supra note 130. See also Roundtable
Transcript, supra note 109, at 221 (Richard Phillips, K&L Gates)
(``[I]f you had [disclosure of 12b-1 fees] in dollars and cents
terms, if you had it in the account statements * * * I think you
would get a mutual fund investing public that is more sensitive to
the issue of sales charge. And, over the long run, it would have a
competitive effect of a more informed investing public.'').
\326\ See, e.g., Comment Letter of the ICI (July 19, 2007);
Comment Letter of W. Hardy Callcott (June 18, 2007). However,
another commenter argued that account statement disclosure could
provide useful information to shareholders. See Comment Letter of
Access Data Corp. (July 19, 2007).
\327\ We note that we have addressed this issue in part by
requiring that prospectuses include an example of the costs an
investor would pay on a hypothetical $10,000 investment in the fund.
See Item 3 of N-1A.
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Is our assumption correct? Or should we pursue the
recommendations made by the GAO and require account statement
disclosure of the actual dollar amount of asset-based distribution
fees? Would such account statement disclosure be helpful or useful to
investors? Have technological advances permitted account statement
disclosure to be provided to investors without undue costs?
K. Proposed Conforming Amendments to Rule 11a-3
Section 11(a) of the Act requires exchanges between funds to be
based on the relative net asset values of the shares to be
exchanged.\328\ Rule 11a-3 provides a conditional exemption permitting
funds and fund underwriters to charge a sales load on shares acquired
in certain exchanges between funds within the same fund group. Among
other things, the rule limits the total combined sales load that may be
charged on shares that have been subject to an exchange (i.e., all
sales loads incurred on both the exchanged and acquired shares) to the
highest sales load rate applicable to those shares (exchanged or
acquired) in the absence of an exchange.\329\ This provision is
designed to give shareholders credit for all sales loads paid in
connection with a purchase of fund shares, regardless of whether the
sales load was paid with respect to the exchanged or acquired
shares.\330\
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\328\ Section 11(a) of the Act makes it unlawful for a fund or
its principal underwriter to make an exchange offer to the fund's
shareholders or to shareholders of another fund on any basis other
than the relative net asset values of the shares to be exchanged,
unless the terms of the offer are approved by the Commission or
comply with Commission rules governing exchanges.
\329\ Rule 11a-3(b)(4).
\330\ Offers of Exchange Involving Open-End Investment Companies
and Unit Investment Trusts, Investment Company Act Release No.
15494, at text following n.28 (Dec. 23, 1986) [51 FR 47260 (Dec. 31,
1986)].
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As discussed above, our proposed amendments to rule 6c-10 would
treat traditional sales loads and the sales charge component of
existing 12b-1 fees, (i.e., the ongoing sales charge) similarly under
the Act.\331\ Accordingly, we propose two changes to rule 11a-3 that
would conform that rule with our general approach.
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\331\ See supra note 141 and accompanying text.
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1. Credit for Ongoing Sales Charges Paid
Paragraph (b)(4) of rule 11a-3 requires that funds, in determining
any sales load due upon an exchange, give shareholders credit (i.e.,
reduce the amount of sales load charged on the purchase of new shares)
for their previous payment of sales loads on the shares exchanged, but
does not require funds to give shareholders credit for the payment of
any rule 12b-1 fees. In order to ensure that shareholders are credited
for all sales charges previously paid in connection with a purchase of
fund
[[Page 47095]]
shares, we propose to amend rule 11a-3(b)(4) to require funds to also
give shareholders credit for the payment of ongoing sales charges.
We request comment on our proposed treatment of ongoing sales
charges in rule 11a-3.
Are there reasons not to treat a sales load and an ongoing
sales charge in the same way when determining the amount of sales load
due upon an exchange? Should we require funds to also give credit for
any marketing and service fee paid under rule 12b-2 when calculating
the sales load due upon an exchange? Should we require funds to also
give credit for any 12b-1 fees previously paid on the exchanged shares?
If so, should we limit the credit to fees paid in excess of 25 basis
points (i.e., the asset-based sales charge component of 12b-1 fees)?
Would our proposed amendments to rule 11a-3 result in significant
operational difficulties? Is there a simpler or less costly method of
accomplishing the goal of ensuring that investors receive credit for
ongoing sales charges during rule 11a-3 exchanges than the approach we
are proposing?
2. Deferred Sales Loads Upon Exchange
Rule 11a-3 prohibits funds from imposing a deferred sales load at
the time of an exchange.\332\ The provision was designed to remove the
incentive for fund underwriters to induce shareholders to make
exchanges in order to accelerate its collection of a deferred sales
load.\333\ Under the rule, a fund may not treat an exchange as a
redemption for purposes of assessing a deferred sales load, and thus
may impose a deferred sales load only when the acquired shares are
ultimately redeemed.\334\ When the deferred load is imposed, the fund
must determine the amount of the deferred load by ``tacking'' (i.e.,
adding) the time the shareholder held shares of the exchanged fund to
the time the shareholder held shares of the acquired fund.\335\
However, in determining the amount of the deferred load, a fund may
toll (i.e., exclude) the time the acquired shares are held if a new
sales load is not charged upon the exchange and credit is given to the
investor for any 12b-1 fees paid with respect to the acquired
shares.\336\
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\332\ Rule 11a-3(b)(3).
\333\ See Rule 11a-3 Adopting Release, supra note 186, at text
following n.28.
\334\ Rule 11a-3(b)(5).
\335\ Id.
\336\ Rule 11a-3(b)(5)(i). The rule provides an analogous
provision for acquired shares that have a CDSL. Rule 11a-
3(b)(5)(ii). The rule recognizes that CDSLs typically are reduced
over time to reflect amounts paid by investors indirectly through a
12b-1 plan. We reasoned that ``if a shareholder is making any
payments for distributions through a 12b-1 plan, those payments
should be reflected in a commensurate reduction of the CDSL owed,
[but] * * * tolling would prevent a shareholder from receiving
credit for the 12b-1 payments made while holding the acquired
shares. * * *'' See Offers of Exchange Involving Registered Open-End
Investment Companies and Unit Investment Trusts, Investment Company
Act Release No. 16504, at text following n.35 (July 29, 1988) [53 FR
30299 (Aug. 11, 1988)] (revised proposal of rule 11a-3). Thus, rule
11a-3 permits tolling of the time the acquired shares are held only
if ``a credit is given to investors for any 12b-1 fees with respect
to the acquired shares. * * *'' Rule 11a-3 Adopting Release, supra
note 186, at text accompanying n.35.
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We propose to modify the ``tolling'' provision of rule 11a-3 to
permit funds, in determining the amount of deferred sales load due upon
ultimate redemption, to provide credit only for the sales charge
component of any asset-based distribution fee, i.e., the ongoing sales
charge. Because the marketing and service fee is not considered to be
an alternative sales charge under our proposal, we would not require
funds to give credit for such fees when determining the sales load
payable upon an exchange. In addition, we propose to modify the rule to
clarify that funds must provide credit for ongoing sales charges in
terms of the cumulative rate of the ongoing sales charge previously
paid rather than the amount of fees paid. As discussed previously, we
understand that funds generally do not have the ability to track dollar
amounts of 12b-1 fees that are attributable to individual shareholder
accounts.\337\ In addition, requiring that credit be given in terms of
rates rather than dollar amounts would make rule 11a-3 consistent with
the method of calculating maximum sales loads under rule 6c-10(b).\338\
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\337\ See supra note 170 and accompanying text.
\338\ See supra Section III.D.1 of this Release.
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Should rule 11a-3 require funds to give shareholders
credit for the payment of any marketing and service fee when relying on
the tolling provisions? We request comment on any aspect of our
proposed changes to rule 11a-3. Should rule 11a-3 operate in terms of
dollar amounts instead of rates? Would it be difficult or costly for
funds to comply with the new requirements? Is it difficult or costly
for funds today to comply with the tolling provisions of rule 11a-3? Is
our understanding correct that funds generally do not have the ability
to track dollar amounts of 12b-1 fees? Would it be difficult or costly
for funds to track these amounts?
L. Other Proposed Conforming Amendments
1. Rule 17a-8
Rule 17a-8 provides an exemption from section 17(a) of the Act to
permit mergers of funds with certain of their affiliated persons,
including other funds (affiliated funds), subject to certain
conditions.\339\ Among other requirements, the rule requires the board
of the merging fund to have made certain determinations, the surviving
fund to keep certain records, and the shareholders of the merging fund
to approve of the merger.\340\ The rule allows for affiliated funds to
merge in the absence of a shareholder vote, if, among other conditions,
the 12b-1 fees of the surviving company are no greater than the 12b-1
fees of the merging company.\341\ This condition prevents 12b-1 fees
from being instituted or increased as a result of a merger on which the
acquired fund's shareholders have not had an opportunity to vote.\342\
We propose to preserve this protection by amending rule 17a-8 to
replace references to rule 12b-1 with references to rule 12b-2(b) or
(d) and rule 6c-10(b).\343\
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\339\ ``Affiliated person'' is defined in section 2(a)(3) of the
Act.
\340\ See rule 17a-8(a)(2), (a)(5), and (a)(3), respectively.
\341\ Rule 17a-8(a)(3)(iv).
\342\ Investment Company Mergers, Investment Company Act Release
No. 25666 (July 18, 2002) [67 FR 48512 (July 24, 2002)].
\343\ See proposed amendments to rule 17a-8(a)(3)(iv).
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We request comment on this proposed revision. Should we
continue to permit affiliated funds to merge in reliance on this
provision in light of our new approach to asset-based distribution fees
and the different role that fund directors would have in overseeing
these fees under our proposal? Is there another approach we should take
in amending rule 17a-8 to conform with our proposal?
2. Rule 17d-3
When the Commission adopted rule 12b-1 in 1980, it also adopted
rule 17d-3 because a fund's payments for distribution under a rule 12b-
1 plan may involve it in a ``joint enterprise'' with an affiliated
person that otherwise would be prohibited by section 17(d) of the Act
and rule 17d-1 unless an application regarding the joint arrangement
was filed with the Commission and granted by order.\344\
[[Page 47096]]
The rule grants an exemption for funds to enter into agreements with
certain affiliated persons and the fund's principal underwriter in
connection with the distribution of its shares, provided that such an
agreement is in compliance with rule 12b-1, among other
requirements.\345\
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\344\ See 1980 Adopting Release, supra note 23, at section
titled ``Proposed Rule 17d-3'' (rule 17d-3 was adopted in the same
release as rule 12b-1). Section 17(d) of the Act and rule 17d-1, in
general, prohibit an investment company from entering into a ``joint
enterprise or other joint arrangement or profit-sharing plan'' (as
defined in the rule) with any affiliated person or principal
underwriter (or their affiliated persons) unless the Commission by
order grants an exemption before the agreement goes into effect.
\345\ The Commission stated that prior review and approval as
required by rule 17d-1 would not be necessary if the safeguards of
rule 12b-1 have already been applied to the arrangement. 1979
Proposing Release, supra note 33. The exemption does not extend to
arrangements for the joint sharing of distribution costs by funds
that are affiliates (or affiliates of affiliates) of each other
(e.g., mutual funds in the same fund complex). 1980 Adopting
Release, supra note 23, at section titled ``Proposed Rule 17d-3.''
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We believe that under our proposed new rules, funds should continue
to be afforded the exemption provided by rule 17d-3 with respect to
distribution payments made to certain affiliated persons and the
principal underwriter, so long as those payments are consistent with
the conditions set forth in proposed rule 12b-2 and amended rule 6c-
10.\346\ We therefore propose to revise rule 17d-3(a) to replace the
reference to 12b-1 with references to rule 12b-2(b), rule 12b-2(d) and
rule 6c-10(b) in order to permit a fund to enter into an asset-based
distribution fee arrangement with an affiliated underwriter.\347\
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\346\ We note that fund boards would continue to review and
scrutinize arrangements involving asset-based distribution fees and
ongoing sales charges, as discussed above. See supra section
III.D.4.
\347\ See proposed amendments to rule 17d-3(a).
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We request comment on any aspect of this proposed
revision. Would the revised role of directors in approving asset-based
distribution fees under our proposal make this type of exemption less
warranted? Is there another approach we should take in revising rule
17d-3 to conform with our proposal?
3. Rule 18f-3
Rule 18f-3 permits funds to offer multiple classes of fund shares.
Section (f) of the rule permits funds to convert shares of one class to
shares of another class after a specified period of time, provided
that, among other things, the expenses (including 12b-1 fees) charged
to the converted class are no higher than the expenses of the original
share class. We believe that, under our proposed amendments, funds
should continue to be able to convert shares under the same conditions.
We believe that expenses attributable to proposed rule 12b-2 and
proposed amendments to rule 6c-10 should be taken into account when
making these conversions, much like rule 12b-1 expenses are today. We
therefore propose that rule 18f-3(f)(ii) be amended to delete the
reference to 12b-1 fees and replace it with references to fees under
rule 12b-2(b), rule 12b-2(d) and rule 6c-10(b).\348\
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\348\ See proposed amendments to rule 18f-3(f)(ii).
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We request comment on any aspect of this revision. Is
there another approach we should take in revising rule 18f-3 to conform
with our proposal?
4. Forms N-3, N-4, and N-6
Form N-3 is the registration form used by insurance company
separate accounts registered as management investment companies that
offer variable annuity contracts. Instruction 2 to Item 7(a) requires
separate accounts to disclose, among other things, the principal
activities for which 12b-1 payments are made and the total amount spent
under a 12b-1 plan in the most recent fiscal year, as a percentage of
net assets. We believe that most of the information required to be
disclosed by Instruction 2 to Item 7(a) would continue to be useful to
investors and the Commission, and thus we propose to amend Instruction
2 to Item 7(a) to replace references to rule 12b-1 and 12b-1 plans with
references to asset-based distribution expenses incurred under rule
12b-2(b), rule 12b-2(d) and rule 6c-10(b). The proposal would eliminate
the requirement that registrants disclose the total amount spent in the
most recent fiscal year (although this information would continue to be
available in funds' financial statements), and would instead require
registrants to provide a description of asset-based distribution fees.
As discussed above, disclosure of the aggregate total of asset-based
distribution fees may not be helpful to investors because it primarily
reflects the size of the fund and not the distribution activities that
are paid for with these amounts.\349\ The proposal would retain the
requirement that registrants list the principal types of activities for
which asset-based distribution fees are charged.
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\349\ See supra note 323 and accompanying text.
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As discussed above, under our proposals funds would not be required
to have written ``plans'' that are supervised and approved by the board
of directors. We therefore propose to eliminate paragraphs (ii) and
(iii) of Item 21(f) because these items relate to the specific
operation of a 12b-1 plan that would no longer exist under our
proposal.\350\
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\350\ Item 21(f)(ii) requires a registrant to disclose whether
any interested person or director has a financial interest in the
operation of the 12b-1 plan. Item 21(f)(iii) requires disclosure of
the anticipated benefits of the plan to the fund.
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We request comment whether we should retain any of these
parts of Item 21(f).
We believe, however, that the information required to be disclosed
in paragraph (i) of Item 21(f), which requires registrants to disclose
the manner in which amounts paid by the registrant under a 12b-1 plan
were spent, would continue to be useful to investors and the
Commission. This information may be relevant to an investor making an
investment decision because it discloses the types of services the fund
(and its investors) may receive in exchange for these fees. We propose
to amend Item 21(f) to eliminate references to the 12b-1 plan, and
instead require disclosure of the principal activities paid for through
asset-based distribution expenses incurred under rule 12b-2(b), rule
12b-2(d) and rule 6c-10(b). For the reasons discussed above, we also
propose to amend Instruction 5 to Item 26(b)(ii) \351\ to delete any
references to 12b-1 plans.\352\ However, registrants would be required
to provide the same information with respect to expenses and
reimbursements accrued pursuant to rule 12b-2(b), rule 12b-2(d) and
rule 6c-10(b).
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\351\ Instruction 5 to Item 26(b)(ii) explains how registrants
should include expenses related to 12b-1 fees in the calculation of
their performance data.
\352\ See proposed amendments to Instruction 5 to Item
26(b)(ii).
---------------------------------------------------------------------------
We request comment on any aspect of these proposed
revisions to Form N-3.
We are also proposing to amend the fee tables in Forms N-4 and N-6,
the registration forms used by insurance company separate accounts
registered as unit investment trusts that offer variable annuity
contracts and variable life insurance contracts, respectively. We
propose to replace existing references to ``distribution [and/or
service] (12b-1) fees'' with a new defined term, ``asset-based
distribution fees.'' We also propose to add new instructions that would
define the term ``asset-based distribution fee'' as ``all asset-based
distribution fees paid under rule 12b-2(b), rule 12b-2(d), and rule 6c-
10(b).''
We request comment on these proposed revisions to Forms N-
4 and N-6.
5. Form N-SAR
We are proposing to amend the instructions to Form N-SAR, the
[[Page 47097]]
reporting form that is used by mutual funds for filing annual and semi-
annual reports with the Commission.\353\ Form N-SAR currently requires
funds to answer a series of five questions about their 12b-1 plans in a
yes/no or fill-in-the-blank format, which provides the Commission
information regarding the use and amount of 12b-1 fees. The first of
these questions asks a fund to state whether it has adopted a rule 12b-
1 plan, and if the answer is ``no,'' the fund need not answer the next
four questions.\354\ Because under our new approach funds would no
longer be required to have 12b-1 plans, funds would answer ``no'' to
the first question, and would not be required to respond to the
remaining four questions. Under the proposed amended instructions,
funds with share classes subject to a grandfathered 12b-1 plan (as
discussed in Section N.3 below) would respond ``yes'' to the first
question, and provide the information required in the remaining
questions. Funds that do not have grandfathered 12b-1 plans would
answer ``no'' to the first question, and would not be required to
respond to the remaining four questions.
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\353\ Mutual funds that have effective registrations statements
for their shares under the Securities Act are required to file
annual and semi-annual reports with the Commission on Form N-SAR
under section 30(b) of the Act and rule 30b1-1.
\354\ Item 40 of Form N-SAR.
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Although the operation of grandfathered 12b-1 fees would differ in
certain ways from current 12b-1 fees if the proposal is adopted
(primarily because there would no longer be board approval of a 12b-1
plan), those differences should not affect the disclosures required
under Form N-SAR, and this information could continue to be useful to
the Commission and investors.
We request comment on our proposed changes to Form N-SAR.
Should we delete the Form N-SAR questions related to 12b-1 plans
entirely and not require funds with grandfathered share classes to
answer the questions? Or should we amend the questions so that they
apply not only to funds with a 12b-1 plan, but also to any fund with
asset-based distribution fees pursuant to our proposed new rule 12b-2
and amended rule 6c-10? Is there a continuing need for the information
to be disclosed in the questions related to 12b-1 plans in Form N-SAR
if our proposal is adopted?
6. Regulation S-X
Mutual funds must include in their registration statements and
shareholder reports the financial statements required by Regulation S-
X.\355\ As part of this requirement, mutual funds file a statement of
operations listing their income and expenses.\356\ Under the expense
category, funds currently must state separately all amounts paid in
accordance with a plan adopted under rule 12b-1.\357\ We propose to
delete the reference to rule 12b-1 and replace it with a requirement
that funds list separately, in two line items in the statement of
operations, the portion of this expense that represents marketing and
service fees under proposed rule 12b-2(b), and the portion of this
expense that represents ongoing sales charges under proposed amendments
to rule 6c-10(b) or other fees under rule 12b-2(d).\358\ Multiple-class
funds would be permitted to disclose the marketing and service fees and
ongoing sales charges incurred by each class either in the statement of
operations or in a note to the financial statements, so that investors
in each class would have an understanding of the expenses paid by their
particular distribution arrangement. This change is designed to provide
investors with information about marketing and service fees and ongoing
sales charges in a fund's financial statements and is consistent with
the proposed changes to the prospectus fee table.\359\ In addition,
funds that receive reimbursements relating to distribution would
continue to report these reimbursements as a negative amount and deduct
them from current 6c-10(b), 12b-2(b) or (d) expenses in the statement
of operations.
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\355\ Item 27 of Form N-1A. Article 6 of Regulation S-X contains
special rules applicable to the financial statements of registered
investment companies. 17 CFR 210.6-01 et seq.
\356\ Rule 6-07 of Regulation S-X contains the requirements for
an investment company's statement of operations. 17 CFR 210.6-07.
The statement of operations reports changes in a fund's net assets
resulting from the amount of net investment income, net realized
gains and losses on investments, and net unrealized appreciation or
depreciation of investments.
\357\ 17 CFR 210.6-07.2(f).
\358\ Shares subject to grandfathering under proposed rule 12b-
2(d) would continue to list asset-based fees as a single line item,
as under current practices.
\359\ See supra Section III.J of this Release.
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We request comment on the proposed amendments. Would
listing ongoing sales charges in the statement of operations help
investors understand that they are paying a sales charge as part of
their investment in the fund? Should this information be presented in
the statement of operations separately for each class of the fund? Is a
note to the financial statement the appropriate place to provide this
information? If not, where should we require disclosure of class-
specific information? Should we also require that the conversion period
for the ongoing sales charge be included in shareholder reports to
provide investors with a regular reminder and reference for how long
the fee would be charged?
M. Potential Impact of Proposed Rule Changes
Our rule proposals are designed to resolve many of the difficulties
that investors, as well as fund directors, managers, underwriters, and
intermediaries, have experienced with rule 12b-1 and 12b-1 fees over
the years. We also recognize that, if adopted, our proposals would
affect how some fund groups and their distributors conduct business.
The benefits and potential impacts of the proposed rule changes on
various market participants, which we summarize below, are also
discussed further in the Cost-Benefit Analysis contained in Section V
of this Release.
1. Fund Investors
Our proposals are designed to make it easier for fund investors to
understand fund expenses. As a result, investors would be better able
to select the fund or fund class that offers the combination of costs
and services that is most advantageous for them. In addition, our
proposals would provide for equivalent limitations on sales charges for
shareholders who invest in a fund through a class of shares that
charges front-end sales loads and those who choose to invest in a class
of shares that bears an ongoing sales charge. We believe the proposals
would yield investors two benefits. First, they would protect investors
from the imposition of excessive sales loads, in furtherance of the
goals of section 22(b) of the Act,\360\ by limiting the cumulative
amount of sales charges that an investor could bear directly or
indirectly.\361\ Second, they would promote a fairer allocation of
distribution costs among investors who invest through different share
classes by limiting the extent to which one class of shares (e.g.,
class C shares) may bear these costs. In addition, the proposed rule
amendments may lead to lower distribution costs if greater retail price
competition develops.
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\360\ See supra note 20.
\361\ See infra Section III.N.3 (discussing grandfathered share
classes).
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Some investors wrote to us urging the elimination of rule 12b-1 as
a way of reducing the cost of owning mutual funds.\362\ Although one
consequence of
[[Page 47098]]
the proposed rule amendments may be to reduce distribution costs, the
elimination of asset-based sales charges would not eliminate the need
to compensate fund intermediaries for fund distribution and for the
other services they provide. Investors who do not want to pay 12b-1
fees have available to them a range of funds that do not charge these
fees, although investors in these funds may pay distribution costs
through other means. In recent years, expenses of funds as a group have
begun to decline as more investors have sought funds with lower
expenses, and as index funds and exchange-traded funds have become more
popular with investors.\363\ We believe that more transparent
disclosure of fund expenses may help investors to better evaluate
different fund options. This transparency also may lead to greater
competition among funds and ultimately downward pressure on fund costs.
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\362\ See, e.g., Comment Letter of Melvyn H. Mark (June 17,
2007); Comment Letter of Jack Thomas (June 19, 2007); Comment Letter
of Weiwan Ng (June 19, 2007).
\363\ See, e.g., Fee Trends Report, supra note 22 (discussing
the decline in expense ratios during the past 20 years, but noting
that the expense ratios of stock funds and bond funds increased in
2009).
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2. Fund Intermediaries and Distributors
We received comments from a large number of financial planners,
broker-dealer representatives, and brokerage firm managers who
expressed concern that the ``trail commissions'' or ``service fees''
they receive from the proceeds of 12b-1 fees might be cut off as a
result of this rulemaking, and they could no longer provide ongoing
services to their customers.\364\ These proposals should address these
concerns.\365\ Approximately 80 percent of fund assets that are subject
to 12b-1 fees are charged 12b-1 fees of 25 basis points or less. They
therefore would not be subject to the portion of our rule proposals
related to ongoing sales charges.\366\
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\364\ See, e.g., Comment Letter of Jill Shannon (Aug. 6, 2007);
Comment Letter of Bernard Smit (Oct. 9, 2007); Comment Letter of
Eric Connors (June 19, 2007)). See also Comment Letter Type A and
Comment Letter Type B.
\365\ But see supra notes 100 and 168 of this Release.
\366\ According to industry statistics derived from Lipper's
LANA Database analyzed by our staff, funds that charge 12b-1 fees
have aggregate assets of $4.86 trillion, which we assume is the
source of payments for trail commissions or services fees (or a
combination) to intermediaries. 12b-1 fees of 25 basis points or
less are charged on approximately 82 percent of these assets ($4.0
trillion).
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Intermediaries that may be affected by our proposed rules are
primarily broker-dealers that currently receive payments from the sale
of classes of fund shares that pay 12b-1 fees that exceed 25 basis
points (e.g., class C shares). Under our rule proposals, funds could
continue to pay broker-dealers 12b-1 fees at previously approved levels
for grandfathered shares.\367\ For shares issued after the compliance
date, fund underwriters would likely reduce the stream of payments when
the shares convert to a class that pays no more than 25 basis points of
asset-based distribution expenses (e.g., class A shares) or else find a
different source of revenue to fund the payments. The amount of time
before conversion would depend on the amount of sales load charged on
the class A shares, i.e., the reference load, and the rate of the
ongoing sales charge (the amount of asset-based distribution fees that
exceeds 25 basis points). Thus, for example, if a fund offers class A
shares with a 5.25 percent front-end load and class C shares with an
ongoing sales charge of 75 basis points, then the class C shares would
have to convert no later than seven years from the time of
purchase.\368\ This consequence flows from the premise (discussed
above) that amounts paid by funds in excess of the marketing and
service fee are charged as an alternative to sales loads, and thus are
properly limited by the NASD sales load caps.
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\367\ See infra Section III.N of this Release.
\368\ We calculated the length of the conversion period by
dividing the rate of the front-end load (5.25%) by the rate of the
ongoing sales charge (0.75%).
---------------------------------------------------------------------------
Some commenters and roundtable participants described ``level
load'' classes of shares as providing for an alternative to front-end
or spread-load arrangements, and thus acknowledged them as a form of
sales load designed to support distribution of fund shares.\369\
Others, however, have asserted that the 12b-1 fees associated with
level load funds (often 100 basis points) pay for valuable ongoing
investment advice provided by the intermediary, and are an alternative
to mutual fund wrap fee programs, which often charge a 100 basis point
(or greater) wrap fee.\370\ The use of fund assets to finance personal
advisory services (rather than support fund distribution), however,
raises issues regarding whether those advisory services provided by an
intermediary to a customer years after the sale ought to be payable
from fund assets. Such expenditures arguably do not relate to the
operation of the fund or to the distribution of its shares.
---------------------------------------------------------------------------
\369\ See, e.g., Roundtable Transcript, supra note 109, at 198-
99 (Richard Phillips, K&L Gates) (``I think you have got to separate
the 25 basis point service fee from the 75 basis point sales
compensation fee, or broker's compensation fee. * * * The 75 basis
point substitute for the front-end load * * * is pure sales
compensation.'').
\370\ See, e.g., Comment Letter of Gregory A. Keil (June 1,
2007) (``The current `Class C' share is really the next step toward
a more `advice driven' model * * * removing a `transaction cost'
from the equation--and applying an ``always-on'' Advisory Fee to a
DISCRETIONARY investment vehicle--the mutual fund. * * *''); Comment
Letter of Daryl Nitkowski (July 19, 2007) (``In fact, I believe the
typical 1% fee charged on class C shares represents the best option
for clients who want continuing advice, but do not want to have a
fee based account.'').
---------------------------------------------------------------------------
We request comment on these matters. Are asset-based
distribution fees associated with level load share classes an efficient
means to pay for ongoing investment advice?
With respect to level load share class arrangements, roundtable
panelists and commenters raised questions regarding the applicability
of the Investment Advisers Act of 1940 (``Advisers Act'') \371\ to
intermediaries that receive those ongoing fees.\372\
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\371\ 15 U.S.C. 80b.
\372\ Intermediaries that are broker-dealers are excluded from
the definition of investment adviser under the Advisers Act with
respect to advice they provide that is ``solely incidental to the
conduct of [their] business as a broker or dealer'' and for which
they receive ``no special compensation.'' Section 202(a)(11)(C) of
the Advisers Act [15 U.S.C. 80b-2(a)(11)(C)]. Some commenters
asserted that broker-dealers receiving 12b-1 fees are ineligible for
this exclusion. See, e.g., Comment Letter of Ron A. Rhoades (June
18, 2007) (``It is clear from various comments recently submitted by
broker-dealer firm registered representatives, as well as * * *
industry representatives and the ICI, that 12b-1 fees are being
utilized as `special compensation' for advice which is ongoing * * *
and which clearly cannot be considered incidental to the mutual fund
sales transaction * * *. I would submit that the payment of 12b-1
fees for such purposes violates the Investment Advisers Act, when
such fees are paid in connection with brokerage (not investment
advisory) accounts.''); Comment Letter of Harold Evensky (June 26,
2007). See also Roundtable Transcript, supra note 109, at 203
(Barbara Roper) (``The other thing I would just like to point out,
having listened to today's discussion, this advice we're getting
doesn't sound remotely like anything I would call solely incidental
to product sales. And these fees sound a lot like special
compensation for advice.''). See also Beagan Wilcox Volz, Class
Action Firm Mounts Legal Attack on 12b-1 Fees, Ignites (Apr. 9,
2010) (discussing recent lawsuits alleging that broker-dealers may
not properly receive 12b-1 fees without registration as investment
advisers).
---------------------------------------------------------------------------
We request comment on these matters, and whether the
conversion provisions of our proposed rules would appropriately address
them by requiring a nexus between the sale of a share of a mutual fund
and the amount of ongoing sales charges an intermediary's customer pays
through the fund.
Finally, we note that our proposed relaxation of restrictions on
retail price competition could provide fund intermediaries with greater
control over the pricing of fund shares sold to their customers by
permitting intermediaries to establish their own sales loads
specifically tailored for their customers. This may result in greater
competition
[[Page 47099]]
among intermediaries and in particular may impact smaller broker-
dealers that lack the distribution capacity and negotiating ability of
larger broker-dealers. However, some smaller broker-dealers may use
this alternative to create new pricing structures that permit them to
better compete with larger broker-dealers.
We request comment on the likely effects on competition
that may result from our proposal, including the effects with regard to
smaller broker-dealers.
3. Fund Managers and Principal Underwriters
Our proposals would largely preserve existing distribution
arrangements, and should provide fund managers, directors, etc., with
greater legal certainty regarding many distribution financing practices
that have developed over the years.\373\ In this regard, our proposals
would respond to the many calls we have received from mutual fund
managers and others to revise rule 12b-1 in a way that recognizes that
12b-1 fees are today a substitute for sales loads, and to eliminate the
procedural requirements of the rule that they view as outdated.\374\
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\373\ One of the uncertainties involves whether fund boards can
appropriately approve continuation of 12b-1 fees for funds that are
no longer selling shares. See Standard & Poor's, Closed Funds and
12b-1 Fees (Aug. 2008) (http://www2.standardandpoors.com/spf/pdf/index/concept_12B1-Fess&ClosedFunds.pdf) (the existence of 12b-1
fees in funds closed to new investments may seem ``counter-
intuitive,'' but may be appropriate when viewed as a substitute for
a sales load).
\374\ See supra Section II.E.
---------------------------------------------------------------------------
Today's proposals are designed to address the criticism of funds
and fund managers expressed by investors, the academic community, and
the financial press who argue that rule 12b-1 fees may not collectively
benefit fund shareholders because they do not produce economies of
scale and, in fact, operate to increase fund expense ratios.\375\ We
anticipate that the proposed rules, if adopted, would shift the focus
from whether fund expenses are increased by a 12b-1 fee to whether the
sales charges imposed by a particular fund are appropriate in light of
the services provided by the intermediary. This is the issue we believe
investors should be exploring before they decide to invest in a fund
and pay sales charges.
---------------------------------------------------------------------------
\375\ See, e.g., Haslem, supra note 108; William Dukes et al.,
Mutual Fund Mortality, 12b-1 Fees, and the Net Expense Ratio, 29 J.
Fin. Res. 235 (2006); Charles Trzcinka & Robert Zweig, An Economic
Analysis of the Cost and Benefits of SEC Rule 12b-1, Monograph
Series in Finance and Economics 67 (Leonard N. Stern School of
Business, NYU) (1990). See also William P. Dukes & James B. Wilcox,
The Difference Between Application and Interpretation of the Law as
It Applies to SEC Rule 12b-1 Under the Investment Company Act of
1940, 27 New Eng. L. Rev. 9 (1992).
---------------------------------------------------------------------------
4. Small Fund Groups
Some fund and broker-dealer industry participants expressed concern
about the possible effects of changes to rule 12b-1 on smaller fund
groups. Several asserted that use of fund assets to pay for
distribution has played an important role in permitting smaller fund
groups to compete with larger fund groups for the attention of
intermediaries by permitting them to access a wide array of
distribution networks.\376\ Of particular importance to small funds is
their continued ability to use fund assets to pay for participation in
fund supermarkets,\377\ which are an important means by which investors
find smaller fund groups.\378\ A number of studies of the role of
brokers and fund supermarkets in selling shares of mutual funds offered
by smaller fund groups appear to support these assertions.\379\
---------------------------------------------------------------------------
\376\ See, e.g., Roundtable Transcript, supra note 109, at 67-68
(Mellody Hobson, Ariel Capital Management). See also Comment Letter
of Thornburg Investment Management (July 19, 2007) (``[L]arge
brokerage firms have increasingly become more open to using funds
managed by independent advisors, rather than relying entirely on in-
house managed products'' because of compensation from 12b-1 fees);
Comment Letter of the Securities Industry and Financial Markets
Association (July 19, 2007) (``[A]vailability of 12b-1 fees makes
smaller funds more attractive to larger intermediaries, and
correspondingly smaller intermediaries, that do not enjoy the same
economies of scale as larger ones, are able to support and offer a
broader choice of funds for their clients''); Comment Letter of the
ICI (July 19, 2007) (``[T]he ability of small funds to assess asset-
based distribution fees has enabled these funds to remain
competitive by allowing them to gain access to a wider array of
distribution channels * * *'').
\377\ See supra note 96.
\378\ See Comment Letter of Charles Schwab & Co., Inc. (July 16,
2007) (``Repeal of rule 12b-1 would undoubtedly restrict a fund's
ability to rely on supermarkets and their superior infrastructure,
and, in particular, we believe it would have a disproportionate
impact on smaller and new funds that lack the resources outside of
fund assets to pay for shareholder servicing.'').
\379\ Conrad S. Ciccotello et al., Supermarket Distribution and
Brand Recognition of Open-End Mutual Funds, 16 Fin. Servs. Rev. 309
(Winter 2007) (http://findarticles.com/p/articles/mi_qa3743/is_200701/ai_n25499878) (fund families that are focused and smaller in
size are more likely to rely on fund supermarkets for distribution);
Xinge Zhao, The Role of Brokers and Financial Advisors Behind
Investments Into Load Funds (August 2003) (http://ssrn.com/abstract=438700) (brokers and financial advisors are more likely
than self-directed investors to allocate investment dollars to
smaller funds).
---------------------------------------------------------------------------
In developing our proposals, we have considered their potential
effect on smaller fund groups. A representative of a smaller fund group
participated in our roundtable discussion, and our staff met with
representatives from other small fund groups to listen to their
concerns and explore ways in which we might address them.
We believe that our proposal reflects consideration of the concerns
small fund groups shared with us, and would preserve their ability to
compete with larger fund groups. Based on an analysis of data collected
from the Lipper LANA Database by our staff, we estimated that
approximately 108 ``small fund groups,'' offered 189 classes of fund
shares to the public.\380\ Our analysis found that of these classes,
166 (88 percent) either charged no 12b-1 fee or charged a 12b-1 fee of
25 basis points or less.\381\ The remaining 23 classes (12 percent),
under our proposal, would be required to comply with the limits on
ongoing sales charges, reduce their distribution expenditures, or
otherwise change their distribution arrangements. Alternatively, as
discussed above, where non-distribution related expenses are now paid
under 12b-1 plans, many funds may be able to allocate that portion of
their existing 12b-1 fees to administrative expenses, and thus ensure
that their asset-based distribution expenses fall within the limits of
the 25 basis points marketing and service fee.\382\
---------------------------------------------------------------------------
\380\ We are using, for purposes of our estimates, the
definition of ``small business'' or ``small entity'' that we use for
purposes of the Regulatory Flexibility Act [5 U.S.C. 601, et seq.].
Rule 0-10 under the Act defines a ``small entity'' for purposes of
the Act as a group of related management companies (funds) that has
net assets of $50 million or less as of the end of its most recent
fiscal year.
\381\ 111 classes (59 percent) do not have a 12b-1 plan in
effect.
\382\ See supra Section III.C of this Release. See also
Roundtable Transcript, supra note 109, at 89 (Mellody Hobson, Ariel
Capital Management) (explaining that Ariel funds may treat 15 basis
points of a 40 basis point fund supermarket fee as a sub-transfer
agent fee.).
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Only 11 of the small fund groups (6 percent) offered class C
shares, and fund assets attributable to these classes amounted to only
$60 million of assets (0.2 percent of small fund group assets). Based
on this data, we do not believe that our proposals would require many
small funds to restructure their fund classes.\383\
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\383\ Our staff also evaluated the potential impact of our
proposal on somewhat larger fund groups--those with less than $250
million of assets under management--and obtained similar results.
This group consisted of 191 fund groups that offered 497 share
classes. Of these classes, 397 (79.9 percent) carried no 12b-1 fee
or a fee of 25 basis points or less. Only 22 of the 191 fund groups
offered class C shares (11.5 percent), with total assets of
approximately $400 million (3.5 percent of the assets of these fund
groups). See also Section V.B of this Release.
---------------------------------------------------------------------------
We request comment on the impact of our proposals on small
fund groups. In particular, we request comment on the competitive
impact of our rule proposals on smaller fund groups. Is
[[Page 47100]]
this data correct? Should our rules treat small fund groups differently
than larger fund groups?
5. Retirement Plans
Many investors invest in mutual funds through tax-advantaged
retirement plans, such as 401(k) plans.\384\ Some of these funds use
fund assets to compensate plan administrators for services provided to
plans and plan participants, including recordkeeping, sub-accounting,
transaction processing, account maintenance services, and participant
education.\385\ Many of these payments essentially reimburse plan
administrators for costs they incurred to provide services (such as
shareholder recordkeeping) that typically funds would have to bear as
operational expenses for direct accounts.\386\ Other payments, in whole
or in part, may be distribution related, and thus many funds today make
them to plan administrators and financial intermediaries pursuant to a
rule 12b-1 plan.\387\ Different funds take different approaches to
paying these expenses. Some funds may specifically identify operational
costs and pay them outside of rule 12b-1.\388\ Other funds might, for
convenience, use 12b-1 fees to pay all of these expenses to avoid the
need to determine exactly which of the expenses contribute to fund
distribution.\389\
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\384\ According to data compiled by the ICI, 36 percent of long-
term mutual fund assets were held in tax-advantaged retirement plans
as of the end of 2009. See 2010 ICI Fact Book, supra note 6, at 112.
\385\ See Comment Letter of The Spark Institute, Inc. (July 17,
2007).
\386\ See Roundtable Transcript, supra note 109, at 79 (Charles
P. Nelson, Great-West Retirement Services).
\387\ See Deloitte Consulting LLP, Inside the Structure of
Defined Contribution/401(k) Plan Fees: A Study Assessing the
Mechanics of What Drives the `All-In' Fee (Spring 2009--updated June
2009) (conducted by Deloitte Consulting LLP for the ICI) (http://www.ici.org/pdf/rpt_09_dc_401k_fee_study.pdf) (noting portions
of the distribution fee may be used to compensate financial
intermediaries and service providers for services provided to the
plan and its participants and to offset recordkeeping and
administration costs). To the extent that plan administrators
receive these fees as compensation for the sale of fund shares,
broker-dealer registration may be required unless an exemption is
available. See supra note 168. As discussed previously, broker-
dealer registration would be required if a plan administrator
received the proceeds of an ``ongoing sales charge'' under the
proposal.
\388\ See Thomas P. Lemke & Gerald T. Lins, Mutual Funds Sales
Practices Sec. 5:1 (Aug. 2009) (noting that third-party services in
retirement plans may be paid by employer subsidies, direct charges
to employees, or fees included in mutual fund expenses, such as rule
12b-1 fees and service fees).
\389\ See Paul G. Haaga, Jr. & Michele Y. Yang, Practicing Law
Institute, Distribution of Mutual Fund Shares: Rule 12b-1, Corporate
Law and Practice Course Handbook Series (June 1998) (indicating that
rule 12b-1 fees may cover things that are not purely ``sales'' or
``distribution'' and pointing out that many fund groups subsidize
the cost of 401(k) recordkeeping).
---------------------------------------------------------------------------
According to the Investment Company Institute, retirement plan
assets are typically invested in low cost funds.\390\ Approximately 80
percent of 401(k) plan assets are held in mutual fund share classes
that pay no 12b-1 fees or 12b-1 fees of 25 basis points or less.\391\
If our proposals are adopted, we would therefore expect that funds
could continue to make the payments from the proceeds of the marketing
and service fee.
---------------------------------------------------------------------------
\390\ See ICI, The Economics of Providing 401(k) Plans:
Services, Fees and Expenses, 2008 (Aug. 2009) (http://www.ici.org/pdf/fm-v18n6.pdf).
\391\ See id. at 9.
---------------------------------------------------------------------------
Some funds with higher 12b-1 fees may identify a portion of those
expenditures as not distribution related and treat them accordingly,
and may thus be able to reduce their distribution related payments so
that they do not exceed the limits of the marketing and service fee. As
a result, these funds would not be subject to the ongoing sales charge
limits discussed above. Other funds, however, may be required by our
rule proposals to treat a portion of their 12b-1 fee as an ongoing
sales charge and provide for a conversion period. We understand that
many plan administrators currently do not track and age shares both
because plan beneficiaries do not pay taxes on capital gains realized
on sales of shares in retirement plans and because many (or most) plans
do not offer share classes that impose CDSLs.\392\ Plan administrators
would have to either develop this capability, which most other
intermediaries have, or offer only classes of shares that do not impose
an ongoing sales charge, i.e., classes of shares that carry an asset-
based distribution fee of only 25 basis points or less.\393\
---------------------------------------------------------------------------
\392\ See Comment Letter of Charles P. Nelson (June 19, 2007)
(``B and C shares usually aren't used by group retirement plan
platforms due to the back-end loads that are assessed, which cause
recordkeeping problems at the participant level.''). Some retirement
plans do, however, invest in share classes that require the tracking
of share lots. See The Economics of Providing 401(k) Plans:
Services, Fees, and Expenses, supra note 390 at Appendix (the ICI
estimates that approximately one percent of 401(k) assets invested
in mutual funds are invested in class B shares). We also understand
that in light of rule 22c-2, some plan administrators now track the
holding periods of fund shares to ensure that redemption fees are
properly assessed.
\393\ This issue is also raised in the context of insurance
company separate accounts, as discussed in Section III.H of this
Release, supra. We discuss the potential costs of implementing a
conversion feature in Section V of this Release, infra.
---------------------------------------------------------------------------
A small number of funds today issue a class of shares created
especially for retirement plans, often called ``R shares.'' R type
shares typically carry a 12b-1 fee of 50 to 100 basis points that
generates sufficient revenue to pay for a substantial amount of plan
expenses. The Commission staff estimates that less than two percent of
plan assets are invested in R shares.\394\ Treating amounts deducted in
excess of 25 basis points as an ongoing sales charge and eventually
converting these shares may not be a viable option for retirement plans
with R share classes because plan expenses are ongoing. Thus, our
proposal would likely make R shares a less attractive investment option
for plans to offer.
---------------------------------------------------------------------------
\394\ The staff's estimate is based in part on information
obtained from Lipper's LANA Database.
---------------------------------------------------------------------------
We request comment on the potential consequences of our rule
proposals on R shares, and whether investors would be harmed.\395\ We
also note that public policy, as embodied in the securities laws we
administer and the laws administered by other agencies, favors
transparency of expenses.\396\
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\395\ We believe that our proposal will complement disclosure
initiatives proposed by the Department of Labor (``DOL''), which
were designed to ensure that retirement plan participants and
beneficiaries could make informed investment decisions about their
retirement savings. Fiduciary Requirements for Disclosure in
Participant-Directed Individual Account Plans, 73 FR 43014 (July 23,
2008). The proposed DOL regulation would require, among other
things, enhanced disclosure of the fees and expenses of certain
retirement plans and their investment options. Id.
\396\ See, e.g., Employee Retirement Income Security Act of 1974
(29 U.S.C. 1001, et seq.); U.S. Dept. of Labor, Reasonable Contract
or Arrangement Under Section 408(b)(2)--Fee Disclosure (Dec. 7,
2007) [72 FR 70988, 70995 (Dec. 13, 2007)]. See also U.S. Dept. of
Labor, Reasonable Contract or Arrangement Under Section 408(b)(2)--
Fee Disclosure (July 6, 2010) [75 FR 41600 (July 16, 2010)] (interim
final rule).
---------------------------------------------------------------------------
Do R share classes subsidize significant plan expenses or
obscure plan costs by bundling them with mutual fund costs? Are R
shares most attractive to plan sponsors that either are unable or
choose not to bear plan expenses as an employee benefit? Does this tend
to obscure that plan participants are paying the costs themselves
through their investments? Do payments to plan administrators from the
proceeds of 12b-1 fees on R shares pay for services that may not be
exclusively attributable to the funds in which those assets are
invested? If so, then are fund assets potentially being used to pay for
services to non-fund investors (i.e., not for exclusive benefit of fund
investors)? \397\
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\397\ We understand that representatives from the fund industry
have asserted that because the plan rather than plan participants is
the legal owner of the fund shares, the use of plan assets will
exclusively benefit the fund shareholder. This reliance on legal
ownership is, however, inconsistent with the justifications given
for the use of fund assets to pay for sub-accounting, transfer
agency and other plan expenses. If the plan is the owner for purpose
of this analysis, then only the cost of effecting plan transactions
and maintaining records (and not transactions of plan beneficiaries)
would be legitimate fund expenses.
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[[Page 47101]]
N. Transition
If we adopt the rule and amendments we are proposing today, we
expect to provide for a transition period in order to minimize
disruption and costs to funds, fund shareholders, and those who
participate in the distribution of fund shares.
1. Effective Date
We would expect to provide for an effective date within 60 days of
issuing a release adopting the proposed amendments, which would permit
(but not require) funds to take advantage of the new rules quickly.
We request comment on the effective date.
2. Compliance Period
We would anticipate providing a compliance period of at least 18
months after the effective date in the adopting release for funds to
come into compliance with rule 12b-2, amended rule 6c-10, and the other
amendments, for new shares sold. Although we want to provide fund
shareholders with the benefits we believe will be afforded by the rule
amendments as soon as possible, we are sensitive to the operational
consequences of the changes we are proposing, and the potential
complexities of altering existing fund distribution arrangements. We
believe a period of 18 months should be sufficient for funds and fund
managers to make the necessary changes to their operating systems,
distribution and other agreements, and registration statements.
We request comment on the length of the compliance period,
particularly in light of the ``grandfathering'' provisions we describe
below.
3. Grandfathering
a. Grandfathered Classes and Shares
Five-year grandfathering period. Under our proposal, funds would be
required to comply with the changes discussed above with respect to all
shares issued after the compliance date of the new rules. We would
provide a five-year grandfathering period after the compliance date for
share classes issued prior to the compliance date, and that deduct fees
pursuant to rule 12b-1 as it exists today, after which those shares
would be required to be converted or exchanged into a class that does
not deduct an ongoing sales charge.\398\ New sales would not be
permitted in grandfathered share classes after the compliance date of
the new rules.\399\
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\398\ Proposed rule 12b-2(d).
\399\ Dividends or other distributions on the old shares,
however, could be reinvested in the same share class as the shares
on which the dividend or distribution was declared. These
investments are not considered ``sales'' of securities for purpose
of the Securities Act and this grandfathering provision. See
Interpretation of the Division of Corporation Finance Relating to
Dividend Reinvestment and Similar Plans, Securities Act Release No.
5515 (July 22, 1974), 4 SEC Docket 623 (Aug. 6, 1974).
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We are proposing this five-year grandfathering period so that
investors, including those in classes currently subject to rule 12b-1
plans, would benefit from the protections provided by the proposed new
rules. The grandfathering period is also designed to avoid
unnecessarily disrupting existing distribution arrangements under which
fund underwriters may have advanced commissions to pay dealers who have
sold fund shares, and who may depend upon cash flow from existing rule
12b-1 fees. The five-year grandfathering period would provide time for
funds and dealers to revisit and revise existing arrangements to
reflect the approach to asset-based distribution fees we are proposing
today. This period could allow the existing 12b-1 classes to wind down
in an orderly manner. The five-year period is designed to allow
sufficient time for funds and their boards to institute any necessary
conversion or exchange procedures, and prepare to transition all
remaining assets out of grandfathered 12b-1 classes.
We request comment on the proposed grandfathering period for the
transition of existing shares into shares that comply with any new
rules we adopt.
Does this approach make sense in light of the compelling
need for the regulatory changes we have discussed in this Release?
Should we not provide a grandfathering period and instead require
compliance immediately? Should we provide a shorter or longer period
than five years (e.g., one, three, eight, or ten years)? Instead of a
five-year grandfathering period, should we permit the grandfathering of
12b-1 share classes to continue indefinitely?
Should the proposed grandfathering period apply only to
certain types of classes, such as ``level load'' share classes, and not
apply to other classes, permitting them to convert on their own
schedules? What benefits might result from such an approach? Should the
proposed grandfathering period apply only to classes that charge a
certain level of 12b-1 fees (e.g., 12b-1 fees greater than 50 or 75
basis points)?
Alternative transition approaches. We also request comment on
alternative approaches to carrying out the transition of existing share
classes into classes that comply with any new rules we adopt.
Should we adopt a ``sunset'' provision requiring that, by
a certain date in the future, all share classes that do not conform to
the new rules must be converted or exchanged into share classes that do
conform to the new rule? Should we require, in connection with this
approach, that shares in an existing fund class that are charged 12b-1
fees at a certain rate per annum be converted or exchanged into shares
of a class that are charged a total of marketing and service fees and
ongoing sales charges at the same or lower rate per annum? For example,
under this approach, shares in an existing class that are currently
charged a 12b-1 fee of 100 basis points would have to be converted or
exchanged into a class that charges a marketing and service fee of no
more than 25 basis points, and an ongoing sales charge of no more than
75 basis points for a limited time period. Should such an approach also
take into account the existence of contingent deferred sales loads in
existing classes or classes into which shareholders may be converted or
exchanged?
In addition, if we were to adopt this approach, when
should we require that all fund shares be converted or exchanged into
shares that comply with the new rules? By the compliance date of the
rules (i.e., 18 months), or within a shorter period (e.g., six months
or one year) or longer period (e.g., two, three, five or seven years)
of time? Should we exclude from the sunset provision any shares (such
as certain B shares) that by their terms already convert automatically
into shares with no ongoing sales charge?
We request comment whether certain share classes would
encounter special difficulty in complying with the proposed five-year
transition period. For example, R share classes (which often charge a
50 basis point asset-based distribution fee for an indefinite period)
may not be designed to convert to another class, and are often
structured to pay certain costs that might otherwise be paid by the
plan provider or the plan participants. If these classes are required
to transition into a class that does not charge an ongoing sales charge
after five years, this may result in a situation in which fees used to
pay for these services may no longer be available. However, as
discussed previously, this situation could also arise after the
conversion period of an ongoing sales charge R
[[Page 47102]]
share class under our proposal.\400\ Does the proposed grandfathering
period pose any special issues for certain share classes? If so what
type of issues, and how should we deal with them? Should we exempt any
funds or share classes from the requirement to eventually end existing
12b-1 share classes? Should we provide different grandfathering periods
for different funds or classes? If so, how should we identify and
define those funds or classes?
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\400\ See supra Section III.M.5.
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Should we take another approach to dealing with the
problem of old 12b-1 share classes other than grandfathering or a
sunset provision, and if so what should that approach require? Should
we instead require funds to make special exchange offers to
shareholders of old classes?
Funds could comply with the new rules by adding a conversion
feature to newly issued shares. These funds would disclose in their
prospectuses that shares issued before a specified date (the compliance
date or earlier) will not convert on the same schedule as new shares
would convert.
Would this approach confuse shareholders? If so, should we
require that shares offered under the new rules be issued in a separate
class from grandfathered shares?
b. Operation of Grandfathered Classes
During the grandfathering period, under proposed rule 12b-2(d),
funds could continue to charge 12b-1 fees on grandfathered share
classes at the same (or lower) rate as was approved in the fund's 12b-1
plan.\401\ A fund that wants to increase the rate of distribution fees,
as a result, would have to comply with the proposed new rules. Because
the level of fees charged on old share classes could not be increased,
we do not believe any investor protection purpose would be served by
requiring these funds to continue to have a formal 12b-1 plan, if we
adopt these proposed rules. Thus, directors could eliminate mandatory
provisions of 12b-1 plans that require board annual approval, quarterly
reports, and allow for board or shareholder termination of plans.\402\
Directors would continue to exercise responsibility over the 12b-1
plans in accordance with their general oversight responsibilities. In
addition, pursuant to their broad authority, directors could terminate
the plan at any time.
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\401\ Proposed rule 12b-2(d)(2).
\402\ Proposed rule 12b-2(d)(1).
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After the expiration of the proposed grandfathering period,
grandfathered shares would be required to be converted or exchanged
into a class of shares that does not charge an ongoing sales charge. We
are concerned that permitting the deduction of an ongoing sales charge
on grandfathered fund shares could continue to result in shareholders
overpaying for distribution. In addition, it may lead to operational
and administrative difficulties in identifying the asset-based
distribution fees that the shareholders may have already paid and
providing proper credit for these fees. Not permitting the deduction of
ongoing sales charges on grandfathered shares that have been exchanged
or converted is likely to reduce investor confusion and provides equal
treatment to investors.
Because under both rule 12b-1 and our proposal a shareholder vote
is required to materially increase the rate of a 12b-1 fee, we would
also require that the marketing and service fee of the class that the
grandfathered shares are exchanged or converted into not be higher than
the 12b-1 fee charged on the shares in the last fiscal year. This is
designed to ensure that shareholders are not transitioned into a class
that charges higher asset-based distribution fees than they agreed to
when they originally bought the fund.
We request comment on any aspect of the proposed grandfathering
provision.
Should we require that directors continue to have
specific, annual approval duties pursuant to existing rule 12b-1 until
those fees are no longer collected? Should the rule provide further
flexibility in addition to what we propose? We request comment on how
grandfathered 12b-1 fees should be presented in the prospectus fee
table. Should classes with grandfathered 12b-1 fees be required to
separate and label their distribution fees just as they would under our
proposed amendment to the fee table (i.e., by assigning the first 25
basis points charged as a marketing and service fee and the remainder
as an ongoing sales charge)? Is there another label for grandfathered
12b-1 fees that would be descriptive without a reference to ``12b-1''?
Instead of providing requirements regarding which class
grandfathered shares would need to be transitioned into after the
expiration of the grandfathering period, should we instead leave the
decision to the discretion of the board? If so, should we provide any
guidance to the board, and what should that guidance provide? For
example, should we require that the board take into account the length
of time that the grandfathered shares have already paid 12b-1 fees, the
rate of the ongoing sales charge that might be charged, the technical
capabilities of the fund and its service providers, or other factors?
4. Shareholder Voting
For funds that decide to convert current 12b-1 share classes to
conform with the proposed rules, proposed rule 12b-2 would prohibit a
fund from instituting a marketing and service fee unless the fee has
been approved by a vote of at least a majority of outstanding voting
securities.\403\ A shareholder vote would not be required if the fund:
(i) Currently deducts from fund assets annual 12b-1 fees of 25 basis
points or less, and does not increase the rate of the fee; or (ii)
reduces the amount of the 12b-1 fees it currently deducts to an annual
rate of 25 basis points or less, and renames the 12b-1 fee a
``marketing and service fee.'' We understand that approximately two-
thirds of fund classes either do not deduct a 12b-1 fee, or deduct a
12b-1 fee of 25 basis points or less annually. The proposed rule also
would not require funds that currently impose a 12b-1 fee to obtain
shareholder approval if the combined ongoing sales charge and marketing
and service fee would not exceed amounts that could be deducted under a
12b-1 plan in effect at the time the proposed amendments, if adopted,
become effective. In those instances, funds only would be required to
separate the 12b-1 fee into a marketing and service fee and an ongoing
sales charge, and treat each fee in conformity with the new rule and
rule amendments.
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\403\ See proposed rule 12b-2(b)(3).
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We believe that, in the circumstances described above, a
shareholder vote would serve no useful purpose because shareholders
have already implicitly approved the fee, and a shareholder vote would
thus impose unnecessary costs on funds and their shareholders.
We request comment on whether a shareholder vote would
serve any purpose in either of these situations.
IV. Paperwork Reduction Act
Certain provisions of our proposal would result in new or altered
``collection of information'' requirements within the meaning of the
Paperwork Reduction Act of 1995 (``PRA'').\404\ The Commission is
therefore submitting proposed rule 12b-2 and proposed amendments to
rule 6c-10 and Form N-SAR under the Act; proposed amendments to Forms
N-1A and N-3 under the Act and the Securities Act; and proposed
amendments to Schedule 14A and rule 10b-10 under the Exchange Act to
the Office of Management and Budget (``OMB'') for
[[Page 47103]]
review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11.
Responses to the collection of information requirements of our
proposals would not be kept confidential.
---------------------------------------------------------------------------
\404\ 44 U.S.C. 3501-3520.
---------------------------------------------------------------------------
The proposed amendments to rule 6c-10 would result in a new
collection of information requirement within the meaning of the PRA.
The title for the collection of information requirement is ``Rule 6c-10
under the Investment Company Act of 1940, `Exemptions for Certain Open-
End Management Investment Companies to Impose Deferred Sales Loads and
Other Sales Charges.' '' If adopted, this collection would not be
mandatory, but would be required in order for a fund to deduct asset-
based distribution fees in excess of the proposed limits in rule 12b-2.
Proposed rule 12b-2 would result in a new collection of information
requirement within the meaning of the PRA. The title for the collection
of information requirement is ``Rule 12b-2 under the Investment Company
Act of 1940, `Investment Company Distribution Fees.' '' If adopted,
this collection would not be mandatory, but would be required in order
for funds to deduct certain asset-based distribution fees. In addition,
our proposal would rescind rule 12b-1 and its associated collection of
information requirement. We are submitting to OMB the proposed
rescission of rule 12b-1's collection of information requirement.
The Commission is also proposing amendments to existing collection
of information requirements titled ``Form N-1A under the Investment
Company Act of 1940 and Securities Act of 1933, `Registration Statement
of Open-End Management Companies.' '' Compliance with the disclosure
requirements of Form N-1A is mandatory. The Commission is also
proposing amendments to existing collection of information requirements
titled ``Form N-3 under the Investment Company Act of 1940 and
Securities Act of 1933, `Registration Statement of Separate Accounts
Registered as Management Investment Companies.' '' Compliance with the
disclosure requirements of Form N-3 is mandatory. The Commission is
also proposing amendments to existing collection of information
requirements titled ``Form N-SAR under the Investment Company Act of
1940, `Semi-Annual Report for Registered Investment Companies.' ''
Compliance with the disclosure requirements of Form N-SAR is mandatory.
The Commission is further proposing amendments to existing collection
of information requirements titled ``Regulation 14A under the
Securities Exchange Act of 1934 and the Investment Company Act of 1940,
`Commission Rules 14a-1 through 14a-16 and Schedule 14A.'' Compliance
with the disclosure requirements of Regulation 14A is mandatory. The
Commission is also proposing amendments to existing collection of
information requirements titled ``Rule 10b-10.'' Compliance with the
disclosure requirements of rule 10b-10 is mandatory.
Finally, the Commission is also proposing a number of technical and
conforming amendments that would not amend the existing collection of
information burdens for rules 11a-3, 17a-8, 17d-3, and 18f-3 under the
Investment Company Act, and Forms N-4 and N-6, and Regulation S-X under
the Securities Act and the Investment Company Act. These technical and
conforming amendments would not constitute new or altered collections
of information because they would not alter the legal requirements of
these rules and forms.\405\ We estimate that the approved burdens for
these rules and forms would not change if our proposal is adopted.
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\405\ As discussed in the cost-benefit analysis in Section V of
this Release, infra, we have estimated that complying with these
amended rules and forms would take the same amount of time and cost
the same amount of money as complying with the existing rules and
forms, with the exception of rule 11a-3. The additional costs that
the staff has estimated that funds may incur as a result of our
proposed amendments to rule 11a-3 are not related to collections of
information in the rule (certain disclosure, recordkeeping, and
notice requirements), but are instead a result of system changes
that funds may undertake. As a result, we do not expect that these
proposed technical and conforming rule and form amendments would
change existing approved collection of information burdens for any
of these rules and forms.
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An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a
currently valid control number. OMB has not yet assigned control
numbers to the new collections for proposed rule 12b-2 and amended rule
6c-10. The approved collection of information associated with Form N-
1A, which would be revised by the proposed amendments, displays control
number 3235-0307. The approved collection of information associated
with Form N-SAR, which would be revised by the proposed amendments,
displays control number 3235-0330. The approved collection of
information associated with Form N-3, which would be revised by the
proposed amendments, displays control number 3235-0316. The approved
collection of information associated with Schedule 14A, which would be
revised by the proposed amendments, displays control number 3235-0059.
The approved collection of information associated with rule 10b-10,
which would be revised by the proposed amendments, displays control
number 3235-0444.
A. Rule 6c-10
Proposed rule 6c-10(c) would give funds and their underwriters the
option of offering classes of shares that could be sold by dealers
subject to competition in establishing sales charge rates. A fund could
rely on this provision if it discloses its election on Form N-1A. This
disclosure would be a collection of information within the meaning of
the PRA. The collection of information for rule 6c-10(c), however, is
incorporated into the total collection of information burden for our
amendments to Form N-1A, discussed below. As a result, the collection
of information burden for proposed rule 6c-10(c) is not a separate
collection of information within the meaning of the PRA.
B. Rescission of Rule 12b-1
We are proposing to rescind rule 12b-1. If adopted, the rescission
would eliminate the current collection of information requirement for
rule 12b-1 in its entirety. Therefore, there would no longer be a
collection of information burden for rule 12b-1.
C. Rule 12b-2
Proposed rule 12b-2(b) would permit funds to deduct a ``marketing
and service fee'' from fund assets that is limited to the maximum rate
permitted by NASD Conduct Rule 2830 for ``service fees.'' In order to
institute or increase the rate of a marketing and service fee after the
initial public sale of class shares, proposed rule 12b-2(b)(3) would
require a fund to obtain approval from a majority of the class's
shareholders. As under proposed rule 6c-10(b)(3), funds would obtain
shareholder approval by soliciting proxies from shareholders, which
would be a collection of information under the PRA on Schedule 14A
under the Exchange Act. As noted above, Schedule 14A has an approved
collection of information which our proposed amendments would change.
As a result, the collection of information burden for proposed rule
12b-2(b)(3) is not a separate collection of information, but is
incorporated into the estimated paperwork burden for Schedule 14A.
Proposed rule 12b-2(c) would maintain the restrictions in current
rule 12b-1(h) that prohibit funds from using brokerage commissions to
finance distribution. Among other things, proposed rule 12b-2(c) would
maintain
[[Page 47104]]
the requirement that a fund (and its board of directors) approve
policies and procedures designed to prevent: (i) The persons
responsible for selecting brokers and dealers to effect the fund's
portfolio securities transactions from taking into account the brokers'
and dealers' promotion or sale of shares issued by the fund or any
other registered investment company; and (ii) the fund, or any
investment adviser or principal underwriter of the fund, from entering
into any agreement or other understanding under which the fund directs
portfolio securities transactions to a broker or dealer to pay for the
distribution of fund shares. The requirement to adopt these policies
and procedures would be a collection of information under the PRA, and
would be mandatory in order to direct brokerage transactions to a
broker or dealer that distributes fund shares. The Commission has
determined that these collections of information would continue to be
necessary to protect against the inappropriate use of fund assets to
finance distribution, and would continue to be used by the Commission
and its examination staff to monitor these activities.
As discussed in the most recent PRA update to rule 12b-1, we
understand that funds (if they intend to pay brokerage commissions to
brokers and dealers who distribute their shares) generally adopt these
policies and procedures when the fund is created, and incur any burden
associated with this collection of information at that time. We assume
that all funds that are currently operating have already adopted these
policies and procedures (if relevant), and therefore only new funds
that begin to operate in the future will incur this burden. As
previously estimated in the most recent update to the rule 12b-1 PRA,
the staff estimates that approximately 300 new funds would begin
operations annually that would comply with proposed rule 12b-2(c) and
adopt these policies and procedures. Based on information received
during conversations with fund representatives, the staff estimates
that adopting these policies and procedures would take a total of
approximately 1 hour of the board of directors' time as a whole, at an
internal time cost equivalent rate of $4500 per hour.\406\ The staff
further estimates that preparing these policies and procedures for
adoption would take approximately 3 hours of internal fund counsel
time, at an internal time cost equivalent rate of $316 per hour.\407\
Finally, the staff estimates that it would cost funds approximately
$800 in outside counsel time (2 hours multiplied by an estimated $400
per hour for outside counsel time)\408\ to adopt these policies and
procedures.
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\406\ The staff has estimated the average cost of board of
director time as $4500 per hour for the board as a whole, based on
information received from funds, intermediaries, and their counsel.
\407\ The staff estimates that the internal time cost equivalent
for time spent by internal counsel is $316 per hour. This estimate,
as well as all other internal time cost estimates made in this
analysis (unless otherwise noted) is derived from SIFMA's Management
& Professional Earnings in the Securities Industry 2009, modified by
Commission staff to account for an 1800-hour work-year and
multiplied by 5.35 to account for bonuses, firm size, employee
benefits and overhead or from SIFMA's Office Salaries in the
Securities Industry 2009, modified by Commission staff to account
for an 1800-hour work-year and multiplied by 2.93 to account for
bonuses, firm size, employee benefits and overhead.
\408\ The staff has estimated the average cost of outside
counsel as $400 per hour based on information received from funds,
intermediaries, and their counsel.
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Therefore, the collection of information related to adopting
directed brokerage policies and procedures pursuant to proposed rule
12b-2(c) would require a total annual burden of 300 hours of director
time (at a total internal time cost equivalent of $1,350,000),\409\ 900
hours of inside counsel time (at a total internal time cost equivalent
of $284,400),\410\ and $240,000 in outside counsel expenses.\411\ The
total annual number of respondents would be 300, the total number of
responses would also be 300, and the annual burden per respondent would
be 4 hours and $800 in costs.
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\409\ This estimate is based on the following calculations: (1
hour of directors time x 300 newly formed funds = 300 hours); (300
hours x $4500 per hour = $1,350,000).
\410\ This estimate is based on the following calculation: (3
hours of inside counsel time x 300 newly formed funds = 900 hours);
(900 hours x $316 per hour = $284,400).
\411\ This estimate is based on the following calculation: ($800
cost of outside counsel time x 300 newly formed funds = $240,000).
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We request comment on these estimates and assumptions. If
commenters believe these estimates and assumptions are not accurate, we
request they provide specific data that would allow us to make a more
accurate estimate.
D. Form N-1A
Form N-1A is the form that funds use to register with the
Commission under the Investment Company Act and to offer their shares
under the Securities Act.\412\ As discussed previously, the proposed
amendments would require funds that file Form N-1A to: (i) Eliminate
the line item currently titled ``Distribution and/or Service (12b-1)
Fee'' and include two new line items (as relevant) titled ``Marketing
and Service Fee'' and ``Ongoing Sales Charge;'' (ii) revise prospectus
narrative disclosure on asset-based distribution fees; and (iii) revise
the SAI disclosure regarding asset-based distribution fees. The
Commission believes that these changes in the collection of information
should better enable fund investors to understand the purpose and use
of the asset-based distribution fees that they may pay. These changes
will be used to better monitor and oversee the use of asset-based
distribution fees by funds, and assist investors in obtaining
information about the use of fund assets. Preparing Form N-1A is a
collection of information under the PRA and is mandatory.
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\412\ There are two types of Form N-1A filings: (i) Initial
filings; and (ii) annual post-effective amendments. Funds usually
incur significantly more time and incur greater costs when first
registering a fund under their initial N-1A filings than when filing
their annual post-effective updates. Therefore, we separately
estimate the burden for each type of filing.
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1. New Defined Term
The proposed amendments would add the defined term ``Asset-Based
Distribution Fee'' to the general instructions of Form N-1A.\413\ This
term would be used in other parts of our proposed amendments to the
form. The additional definition would not affect the form's collection
of information requirements and therefore would not change current
paperwork burden estimates.
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\413\ The proposal would define an ``Asset-Based Distribution
Fee'' as ``a fee deducted from Fund assets to finance distribution
activities pursuant to rule 12b-2(b) (``Marketing and Service
Fee''), rule 12b-2(d), or rule 6c-10(b) (``Ongoing Sales
Charge'').'' Proposed General Instructions to Form N-1A.
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2. Revised Fee Table
The proposed amendments would require funds, in the fee table of
Form N-1A, to replace the current line item titled ``Distribution and/
or Service (12b-1) Fees'' with two line items titled ``Marketing and
Service Fee'' and ``Ongoing Sales Charge,'' as relevant. Only funds
that charge asset-based distribution fees would be affected by these
proposed amendments. Funds would be able to refer to the same
information about asset-based distribution fees that they use to
complete the 12b-1 line item currently in the fee table. All
information necessary to disclose these fees in the fee table would be
readily available, and the staff estimates that funds would not require
any additional resources to disclose the fees on two lines, instead of
one. Therefore, the staff estimates that
[[Page 47105]]
funds would not incur any additional hourly burdens or costs to
complete the fee table as we propose to amend it. As a result, the
staff estimates that the proposed amendments to the fee table would not
change the collection of information currently approved by OMB to
complete the fee table in Form N-1A, either initially or when
submitting a post-effective amendment.
We request comment on these assumptions. If commenters
believe these assumptions are not accurate, we request they provide
specific data that would allow us to make a more accurate estimate.
3. Prospectus Revisions
The proposal would amend Item 12(b) of Form N-1A, which currently
requires funds that have adopted 12b-1 plans to disclose information
about the operation of the plan in the prospectus. The proposal would
eliminate this requirement, and instead require funds to disclose
whether they charge a marketing and service fee or an ongoing sales
charge, and if they do, to disclose the rate of the fees and the
purposes for which they are used. A fund that imposes an ongoing sales
charge would be required to disclose the number of months (or years)
before the shares would automatically convert to another class without
an ongoing sales charge. In addition, we would require a fund offering
multiple classes of shares in a single prospectus (each with its own
method of paying distribution expenses) to describe generally the
circumstances under which an investment in one class may be more
advantageous than an investment in another class.
Based on information received during conversations with fund
representatives, the staff estimates that funds filing initial Form N-
1A registrations would expend approximately the same amount of time and
costs to provide the narrative prospectus disclosure on asset-based
distribution fees under our proposal as they expend under the current
disclosure requirements.
The proposed amendments would also require funds that deduct asset-
based distribution fees to revise their narrative prospectus disclosure
in post-effective amendments. The staff further estimates that the
funds would need to incur a one-time cost and time expenditure to
revise and update existing narrative prospectus disclosure to comply
with the proposal. After this one-time revision and update is complete,
the staff estimates that ongoing costs and time expenditures would
remain the same as current estimates because we expect the revised
disclosures to be of similar length and complexity as the previous
disclosure. The staff expects that the revised narrative prospectus
disclosure would be similar in length to the current narrative, and
thus would not change the number of pages in the prospectus or change
printing costs of the prospectus.\414\ The staff estimates that funds
would use outside legal resources to prepare this one-time amendment to
reflect the proposed new framework. The staff expects that all funds in
a fund family would engage in this one-time update at the same time,
and therefore the costs for revising a series prospectus would be
shared among all funds in the family, thereby reducing the cost for
each post-effective update filer. Based on an analysis of data received
on Form N-SAR and information received from fund representatives, the
staff estimates that there are approximately 379 fund families that may
be affected by this proposed change. The staff further estimates that,
on average, each of these fund families would incur approximately $2000
in one-time costs (for outside legal counsel drafting and review) and
expend 10 hours in internal personnel time (at an internal time cost
equivalent rate of $316 per hour) to revise item 12(b) of Form N-1A to
comply with the proposed changes. The staff therefore estimates that
funds will incur a one-time burden of 3710 hours (at an internal cost
equivalent of $1,197,640) and $758,000 in outside costs associated with
this proposed revision to Item 12(b) of Form N-1A.\415\ The staff
estimates that the proposed amendments would not change the ongoing
currently approved collection of information for Item 12(b) of Form N-
1A.
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\414\ Based on conversations with fund representatives, the
staff understands that, in general, unless the page count of a
prospectus is changed by at least 4 pages, the printing costs would
remain the same.
\415\ These estimates are based on the following calculations:
(379 x 10 hours = 3790 hours); (3790 hours x $316 per hour =
$1,197,640); (379 x $2000 = $758,000).
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We request comment on these estimates and assumptions. If
commenters believe these estimates and assumptions are not accurate, we
request they provide specific data that would allow us to make a more
accurate estimate.
4. Statement of Additional Information
The proposal would amend a number of items contained in the SAI
portion of Form N-1A. Item 19(g) currently requires funds to describe
in detail the material aspects of their 12b-1 plans, and related
agreements, in the SAI. Under the proposal, 12b-1 plans would no longer
be required, and grandfathered funds would no longer be required to
have written ``plans'' that are supervised and approved by the board of
directors; therefore, the proposal would eliminate paragraphs 2 through
6 of Item 19(g).\416\ However, Item 19(g)(1) (which requires disclosure
of the material aspects of a 12b-1 plan, including a list of the
principal activities paid for under the plan and the dollar amounts
spent on each activity over the last year), may help investors to
better understand how the fund uses asset-based distribution fees, and
the proposal would retain it in substance. The proposal would amend
Item 19(g)(1) to eliminate references to a 12b-1 plan, and instead
require disclosure of the principal activities paid for through asset-
based distribution fees (both ongoing sales charges and marketing and
service fees).
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\416\ See supra note 313 and accompanying text.
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The proposal would add new paragraph (d) to Item 25, which would
require funds that have elected to externalize the sales charge
pursuant to proposed rule 6c-10(c) to disclose this election on Form N-
1A. This disclosure is designed to inform interested investors of the
fund's election. The proposal would also make technical conforming
changes to Instruction 3(b) to Item 3; Instruction 5 to Item 26(b)(4);
and Item 27(d)(1) (and Instruction 2(a)(i) to Item 27(d)(1)) to replace
references to 12b-1 fees and plans with references to the appropriate
types of asset-based distribution fee under the proposal. Finally, the
proposal would eliminate existing Item 28(m) of Form N-1A, which
requires a fund to attach its rule 12b-1 plan and any related
agreements as an exhibit to its registration statement. The exhibit
would be unnecessary because proposed rule 12b-2 does not require a
written plan.
The staff estimates that the proposed amendments to the SAI would
result in overall time and cost savings for funds. Funds would incur
savings because of the reduced time required and lower costs to prepare
disclosure materials for Item 19(g).\417\ The staff further estimates
that responding to proposed paragraph (d) of Item 27 would entail
little additional time and no costs, as it would only require a fund to
make a single affirmative statement (if
[[Page 47106]]
applicable) that the fund has taken the election. The staff estimates
that the other proposed technical and conforming amendments to the SAI
would not result in changes in the hourly burdens or cost because they
would not change the legal or disclosure obligations of funds.
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\417\ Generally, most SAIs are not printed in advance, but are
instead printed on demand when requested. The staff estimates that
the proposal would not result in a change in printing costs because
the staff does not expect that the number of pages of the SAI would
be reduced as a result of the proposal, and if there were any
reduction; any savings would be minimal due to the few occasions on
which the SAI is printed.
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Therefore, based on conversations with fund representatives, the
staff estimates that the proposed amendments to the SAI would result in
a net time savings of approximately 10 hours for each fund's initial
filing and of 1 hour for each post-effective amendment (all of which
time would be spent by fund counsel at a time cost equivalent rate of
$316 per hour). Based on a review of information filed with the
Commission on Form N-SAR, the staff estimates that there are
approximately 300 funds with a 12b-1 plan that newly file each year and
7367 funds that have adopted a 12b-1 plan that file post-effective
amendments. The staff further estimates that the amendments would
reduce costs incurred for outside counsel associated with completing
the SAI, by $500 for each initial filing and $150 for each post-
effective amendment. Therefore, the staff estimates that all funds
submitting their initial SAI filing would experience a reduction of
3000 hours (at an internal cost equivalent of $948,000) and a cost
savings of $150,000.\418\ The staff also estimates that all funds
filing post-effective amendments will experience a reduction of 7367
hours (at an internal cost equivalent of $2,327,972) and cost savings
of $1,105,050.\419\
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\418\ These estimates are based on the following calculations:
(300 x 10 hours = 3000 hours); (3000 hours x $316 per hour =
$948,000); (300 x $500 = $150,000).
\419\ These estimates are based on the following calculations:
(7367 x 1 hour = 7367 hours); (7367 hours x $316 per hour =
$2,327,972); (7367 x $150 = $1,105,050).
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5. Change in Burden
In the most recent Paperwork Reduction Act submission for Form N-
1A, the staff estimated that for each fund portfolio or series, the
initial filing burden is approximately 830.47 hours at a cost of
$20,300, and the post-effective amendment burden is approximately 111
hours at a cost of $8894. This hourly burden includes time spent by in-
house counsel, back office personnel, compliance professionals, and
others in preparing the form. The costs include that of outside counsel
to prepare and review these filings.
As discussed above, in total the staff estimates that our proposed
amendments to Form N-1A would result in net time savings of
approximately 10 hours for each fund's initial filing (for a new total
estimate of 820.47 hours) and of 1 hour for each post-effective
amendment (for a new total estimate of 110 hours).\420\ The staff
further estimates that the proposed amendments would reduce costs spent
on outside counsel associated with completing Form N-1A, by $500 for
each initial filing (for a new total estimate of $19,800) and $150 for
each post-effective amendment (for a new total estimate of $8744). The
staff also estimates that the proposed amendments would require each
fund family with any funds that would file a post-effective amendment
to incur approximately $2000 in one-time costs and expend 10 hours in
internal personnel time.
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\420\ This is based on the estimates made previously in this
section that there would be no burden change as a result of our
proposed amendments to the prospectus portion of N-1A and that the
proposed changes to the SAI portion would result in the savings
indicated.
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The staff assumes that only funds that charge asset-based
distribution fees would be affected by our proposed amendments to Form
N-1A and would realize these reduced burdens and cost savings. The
staff estimates that, each year, there are approximately 7367 funds
with 12b-1 plans that file post-effective amendments, and would
therefore be affected by our proposed amendments. The staff estimates
that an additional 300 funds with asset-based distribution fees would
file an initial Form N-1A each year after our proposed amendments would
go into effect. Based on these estimates, the staff estimates that
funds would save a total of 3000 hours and $150,000 when submitting
initial Form N-1A filings each year.\421\ In addition, the staff
anticipates that funds would save approximately 7367 hours, and
$1,105,050 annually when preparing post-effective updates to Form N-
1A.\422\
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\421\ This is based on the following calculations: (300 new
filers x 10 hours savings = 3000 hours in total savings); (300 new
filers x $500 savings = $150,000 total savings).
\422\ This estimate is based on the following calculations:
(7367 amendments x 1 hour savings = 7367 hours in total savings);
(7367 amendments x $150 savings = $1,105,050 total savings).
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Finally, as discussed above, the staff further estimates that all
fund families that file post-effective amendments and have adopted 12b-
1 plans would incur a one-time burden of 3790 hours (at an internal
cost equivalent of $1,197,640) and $758,000 in outside costs when
preparing post-effective amendments to comply with the proposed
amendments for the first time.\423\
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\423\ These estimates are based on the following calculations:
(379 x 10 hours = 3790 hours); (3790 hours x $316 per hour =
$1,197,640); (379 x $2000 = $758,000).
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We request comment on any of these estimates or
assumptions.
E. Form N-SAR
Form N-SAR is the form that registered investment companies use to
make periodic reports to the Commission. Completing Form N-SAR is a
collection of information under the PRA and is mandatory. Our proposed
amendments would add an instruction to Form N-SAR to disregard, for
funds that no longer have 12b-1 plans, four questions (Items 41-44)
that relate to the operation of rule 12b-1 plans (because they would be
irrelevant in light of our proposed new framework for asset-based
distribution fees). However, funds that maintain grandfathered fund
classes would continue to respond to these items.
The total annual hour paperwork burden estimate for Form N-SAR is
107,213 hours. The current approved total number of respondents is
4142, and the total annual number of responses is 7461.\424\ The staff
estimates that there are approximately 1292 management investment
companies that respond to Items 40-44 of Form N-SAR.
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\424\ The staff estimates the number of filers and filings based
on the actual number of EDGAR filings and on other Commission
records.
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The staff estimates that our proposed amendments would reduce the
time it takes funds that do not have grandfathered share classes to
complete Form N-SAR by 0.25 hours, and that there would be no change
for funds that maintain grandfathered share classes. The staff
estimates that, if these amendments are adopted, in the first three
years after adoption, approximately 20% of these 1292 management
investment companies (or 258) will no longer maintain grandfathered
share classes and experience the estimated savings, while the remaining
80% (or 1034) will continue to have grandfathered share classes and
respond to these items. Because Form N-SAR is completed twice a year,
the staff estimates that each filer that no longer responds to these
items would save approximately 0.5 hour annually (at an internal time
cost equivalent rate of $316 per hour). The staff therefore estimates
that our proposed amendments to Form N-SAR would result in an aggregate
incremental time savings of approximately 129 hours (with a total
internal time equivalent cost savings of
[[Page 47107]]
$40,764) \425\ annually compared to the current approved hour burden.
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\425\ This estimate is based on the following calculation: (258
x 0.5 hour = 129 hours); (129 hours x $316 per hour = $40,764).
---------------------------------------------------------------------------
We request comment on these estimates and assumptions.
F. Schedule 14A
Funds must comply with the requirements of Schedule 14A when they
solicit proxies from their shareholders. Our proposal would amend the
required disclosures under Schedule 14A when a fund seeks approvals
from its shareholders to institute or increase the rate of a marketing
and service fee after shares have been offered to the public. The
proposed amendments would remove items regarding asset-based
distribution fees that would be superfluous in light of our proposed
rescission of rule 12b-1 and new rule and rule amendments on asset-
based distribution fees, and would amend certain other items.
Based on conversations with fund representatives and the most
recent PRA update to Schedule 14A, the staff estimates that 75% of the
burden of preparing Schedule 14A filings is undertaken by the fund
internally and that 25% of the burden is undertaken by outside counsel
retained by the fund at an average cost of $400 per hour.\426\ The
staff estimates that 3 funds would solicit proxies each year for the
purposes of seeking approval to implement or increase a fee as required
under proposed rules 6c-10(b)(3) and 12b-2(b)(3) (the same number that
the staff has estimated would solicit proxies under rule 12b-1) because
the staff believes the proposed amendments are unlikely to affect the
number of funds that seek proxy approval from their shareholders. For
each of these 3 funds, the staff estimates that our proposed amendments
to Schedule 14A would create an incremental reduction in burden of 3
hours of fund personnel time (at an internal time cost equivalent rate
of $316 per hour) and reduced costs of $400 for the services of outside
counsel, as a result of the proposed amended disclosures relating to
marketing and service fees on Schedule 14A. The staff therefore
estimates that these amendments would reduce the total annual paperwork
burden of Schedule 14A by approximately 9 hours of fund personnel time
(3 funds x 3 hours) at an internal time cost equivalent of $2844,\427\
and by approximately $1200 (3 funds x $400) for the services of outside
counsel.
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\426\ This cost estimate is based on consultations with several
registrants and law firms and other persons who regularly assist
registrants in preparing and filing proxies with the Commission.
\427\ This estimate is based on the following calculation: (9
hours x $316 per hour = $2844).
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In our most recent PRA submission for Regulation 14A (which
includes Schedule 14A), the staff estimated that there are a total of
7300 respondents who use Schedule 14A, each of whom responds once a
year, for a total of 7300 responses annually. The staff estimates that
this number of respondents would remain the same under the proposed
amendments because the staff does not expect our proposed amendments to
affect the number of funds that seek approval from their shareholders
to institute or increase marketing and service fees. The current
approved aggregate time burden for these respondents is 669,026 hours
and the cost burden is $78,822,387. The staff estimates that the
proposed amendments would reduce this time burden by a total of 9 hours
(3 hours times the 3 respondents affected by our proposed amendments)
for a new total of 669,017 hours, and would reduce the cost burden by a
total of $1200, for a new aggregate total of $78,821,187. This would
represent an average per respondent time burden of 92 hours, and a cost
burden of $10,797.\428\
---------------------------------------------------------------------------
\428\ This is based on the following calculations: (669,017
hours / 7300 respondents = 92 hours); ($78,821,187 / 7300
respondents = $10,797).
---------------------------------------------------------------------------
We request comment on these estimates and assumptions. If
commenters believe these estimates and assumptions are not accurate, we
request they provide specific data that would allow us to make a more
accurate estimate.
G. Form N-3
Form N-3 is the registration form used by insurance company
separate accounts registered as management investment companies that
offer variable annuity contracts.\429\ The proposed amendments would
require separate accounts that file Form N-3 to: (i) Revise prospectus
narrative disclosure on asset-based distribution fees; and (ii) revise
the SAI disclosure regarding asset-based distribution fees. Preparing
Form N-3 is a collection of information under the PRA and is mandatory.
---------------------------------------------------------------------------
\429\ There are two types of Form N-3 filings: (i) Initial
filings; and (ii) annual post-effective amendments. Funds usually
incur significantly more time and incur greater costs when first
registering a fund under their initial N-3 filings than when filing
their annual post-effective updates. Therefore, the staff separately
estimates the burden for each type of filing.
---------------------------------------------------------------------------
The proposal would amend Instruction 2 to Item 7(a) of Form N-3,
which currently requires registrants to list the principal types of
activities for which 12b-1 payments are made and the total amount spent
in the most recent fiscal year, as a percentage of net assets (or, if
the plan has not been in effect for a full fiscal year, a description
of the payments). The proposal would eliminate the requirement that
registrants disclose the total amount spent in the most recent fiscal
year, and instead require registrants to provide a description of
asset-based distribution fees, as defined in the new proposed rule. The
proposal would retain the requirement that registrants list the
principal types of activities for which asset-based distribution fees
are deducted.
As discussed above, funds would no longer be required to have
written plans that are supervised and approved by the board of
directors under our proposed rule amendments. Therefore, the proposal
would eliminate paragraphs (ii) and (iii) of Item 21(f), which relate
to the specific operation of a 12b-1 plan.\430\ Paragraph (i) of Item
21(f) requires registrants to disclose the manner in which amounts paid
by the registrant under a 12b-1 plan were spent. We believe that the
information required to be disclosed in paragraph (i) of Item 21(f)
would continue to be useful to investors and the Commission. Therefore,
we are proposing to amend Item 21(f) to require disclosure of the
principal activities paid for through asset-based distribution expenses
incurred under rule 12b-2(b) and (d) and rule 6c-10(b), deleting
references to 12b-1 plans. For the reasons discussed above, we are also
proposing to amend Instruction 5 to Item 26(b)(ii) to delete any
references to 12b-1 plans. However, registrants would be required to
provide the same information with respect to expenses and
reimbursements accrued pursuant to rule 12b-2(b), rule 12b-2(d), and
rule 6c-10(b).
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\430\ Item 21(f)(ii) requires a registrant to disclose whether
any interested person or director has a financial interest in the
operation of the 12b-1 plan. Item 21(f)(iii) requires disclosure of
the anticipated benefits of the plan to the fund.
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The current approved aggregate time burden to comply with the
collection of information requirements in Form N-3 is 13,024 hours. The
current approved aggregate cost burden is $601,400.
Only registrants that charge asset-based distribution fees would be
affected by our proposed amendments to Form N-3. Based upon a review of
filings with the Commission, the staff estimates that 1 registrant that
currently files on Form N-3 charges asset-based distribution fees, and
would file a post effective amendment. Based upon
[[Page 47108]]
conversations with fund representatives, the staff estimates that it
would cost this registrant approximately $2,000 in one-time costs (for
outside legal counsel drafting and review) and require an expenditure
of 10 hours in internal personnel time (at an internal time cost
equivalent rate of $316 per hour) to revise its prospectus to comply
with the proposed amendments. The staff further estimates, based on
those conversations, that the proposed amendments to Item 21 and
Instruction 5 of Item 26 would result in time savings when completing a
post-effective amendment of a Form N-3 filing. The staff estimates that
this registrant would save approximately 1 hour (at an internal time
cost equivalent of $316 per hour) annually as a result of the proposed
amendments.
The staff further estimates that no new registrants that file on
Form N-3 are likely to charge asset-based distribution fees under
proposed rule 12b-2 and the proposed amendments to rule 6c-10.
Accordingly, the staff estimates that there will be no other changes in
burden hours or costs for Form N-3 as a result of the proposed rule and
rule amendments.
We request comment on these estimates and assumptions.
H. Rule 10b-10
Rule 10b-10 requires broker-dealers to convey basic trade
information to customers regarding their securities transactions. The
proposed amendments would revise rule 10b-10 by requiring disclosure of
additional information related to sales charges in connection with
transactions involving mutual funds, requiring disclosure of certain
additional information in connection with callable debt securities, and
removing certain outdated transitional provisions from the rule. This
collection of information would be mandatory. The information would be
used by broker-dealer customers to evaluate the terms of their own
securities transactions. In addition, the information contained in the
confirmations may be used by the Commission, self-regulatory
organizations, and other securities regulatory authorities in the
course of examinations, investigations, and enforcement proceedings. No
governmental agency regularly would receive any of this
information.\431\
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\431\ Exchange Act Rule 17a-4(b)(1), 17 CFR 240.17a-4(b)(1),
requires broker-dealers to preserve confirmations for three years,
the first two years in an accessible place.
---------------------------------------------------------------------------
The proposed amendments to rule 10b-10, in part, would require
transaction confirmations to disclose additional information about
sales charges associated with purchases and redemptions of mutual fund
shares. The purpose of these changes is to help make the confirmation a
more complete record of the transaction, help mutual fund investors
more fully understand the sales charges they pay, and assist investors
in verifying whether they paid the correct sales charge as set forth in
the prospectus. The proposed amendments to rule 10b-10 also would
require confirmation disclosure of certain additional information about
callable debt securities. The purpose of these proposed amendments is
to provide investors with information necessary to evaluate their
transactions involving callable debt securities, by helping to alert
investors to misunderstandings, avoid confusion, promote the timely
resolution of problems, and better enable investors to evaluate
potential future transactions.\432\
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\432\ The proposal also would delete certain expired
transitional provisions of rule 10b-10 related to securities futures
products; there would be no burden associated with this deletion.
---------------------------------------------------------------------------
The rule would apply to the approximately 5,035 broker-dealers
registered with the Commission. The Commission staff understands,
however, that under the current industry practice confirmations are
customarily generated and sent by clearing broker-dealers (``clearing
firms'') subject to agreements (``clearing agreements'') with
introducing broker-dealers (``introducing firms''). Under this industry
practice, the Commission staff understands that clearing firms would
bear most of the costs associated with updating back-office operations
to accommodate the proposed changes to rule 10b-10.\433\
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\433\ For purposes of this analysis, the staff assumes that all
registered broker-dealers effect transactions in mutual fund shares.
To the extent that some broker-dealers may not effect transactions
in mutual fund shares, the paperwork burdens and costs may be
overstated. Furthermore, for the purposes of this analysis, broker-
dealers that have not entered into clearing agreements with
introducing firms yet generate and send confirmations, are included
as clearing firms in the staff's estimates.
---------------------------------------------------------------------------
Based on filings with the Commission, the staff estimates that of
the 5,035 broker-dealers registered with the Commission, approximately
530 are clearing firms. The Commission staff understands that
approximately 30% of clearing firms, or 160 firms, have developed their
own proprietary systems for generating and inputting the information
necessary to generate and deliver a confirmation. The staff further
understands that the other approximately 70% of clearing firms, or 370
firms,\434\ license platforms from third-party service providers (or
vendors) that, among other things, generate the data necessary to
produce and send confirmations.\435\
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\434\ The staff's understanding is that these firms are usually
small and medium-sized clearing firms, but may also include some
larger firms as well.
\435\ The staff's understanding is that there are three primary
vendors that license platforms used by clearing firms to generate
and send confirmations. In addition to licensing platforms, many
clearing firms may also use vendors to separately print and mail
confirmations to investors.
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Based on the industry's current practices, the staff understands
that the 160 clearing firms with proprietary systems would have a one-
time burden associated with reprogramming software and otherwise
updating back-office systems and platforms to enable confirmation
delivery systems to generate the information required under the
proposed amendments.\436\ The Commission staff further estimates, based
on discussions with industry representatives, that this one-time
programming burden for clearing firms with proprietary back-office
systems would amount to, on average, approximately 4,500 hours per
clearing firm, for a total of 720,000 burden hours.\437\
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\436\ The staff notes that these estimates are based on the
assumption that ongoing sales charges and marketing and service fees
commonly will not change over time for any particular mutual fund.
The staff also assumes that the information necessary to comply with
the proposed changes to rule 10b-10 will be readily available to
clearing firms from various third-party service providers.
\437\ 160 clearing firms with proprietary systems x 4,500 burden
hours = 720,000 burden hours.
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With respect to clearing firms that license vendor platforms
(``clearing firm licensees''), the staff estimates that these vendors
will incur costs similar to those incurred by clearing firms with
proprietary systems to reprogram and update their platform. Thus, staff
estimates that the burden to vendors would be approximately 4,500
burden hours per vendor, resulting in one-time costs to these vendors
of approximately $3.4 million dollars.\438\ Based on discussions with
industry representatives, the staff also understands that clearing firm
licensees would still incur approximately 800 burden hours per firm to
adopt the changes to a vendor's platform and determine that the output
satisfies the requirements of the proposed amendments to the rule. The
staff estimates that the total burden for clearing firm licensees would
be approximately 296,000 total hours.\439\ When we sum the labor hours
borne by clearing firms with proprietary systems with those borne by
clearing firm
[[Page 47109]]
licensees, we estimate that the total one-time hour burden as a whole
for entities registered with the Commission will be 1,016,000 burden
hours.\440\
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\438\ 3 vendors x 4,500 burden hours x $251 dollars per hour =
$3,388,500. The staff estimates per hour costs to be $251.
\439\ 370 clearing firm licensees x 800 burden hours = 296,000
total burden hours.
\440\ (160 clearing firms with proprietary systems x 4,500
burden hours) + (370 clearing firm licensees x 800 burden hours) =
1,016,000 total burden hours.
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The Commission staff understands that once completed, this
reprogramming and systems updating should permit clearing firms to have
automated access to the additional information that would be disclosed
in confirmations. Accordingly, the staff does not believe that there
will be a material increase in the ongoing costs associated with
producing and sending confirmations once the initial one-time
reprogramming costs are completed.
I. Request for Comments
We request comment on whether the estimates provided in this PRA
are accurate. Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission
solicits comments in order to: (i) Evaluate whether the proposed
collections of information are necessary for the proper performance of
the functions of the Commission, including whether the information will
have practical utility; (ii) evaluate the accuracy of the Commission's
estimate of the burden of the proposed collections of information;
(iii) determine whether there are ways to enhance the quality, utility,
and clarity of the information to be collected; and (iv) minimize the
burden of the collections of information on those who are to respond,
including through the use of automated collection techniques or other
forms of information technology.
Persons wishing to submit comments on the collection of information
requirements of the proposed amendments should direct them to the
Office of Management and Budget, Attention Desk Officer for the
Securities and Exchange Commission, Office of Information and
Regulatory Affairs, Room 10102, New Executive Office Building,
Washington, DC 20503, and should send a copy to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090, with reference to File No. S7-15-10. OMB is
required to make a decision concerning the collections of information
between 30 and 60 days after publication of this Release; therefore a
comment to OMB is best assured of having its full effect if OMB
receives it within 30 days after publication of this Release. Requests
for materials submitted to OMB by the Commission with regard to these
collections of information should be in writing, refer to File No. S7-
15-10, and be submitted to the Securities and Exchange Commission,
Office of Investor Education and Advocacy, 100 F Street, NE.,
Washington, DC 20549-0213.
V. Cost-Benefit Analysis
A. Background
The Commission is sensitive to the costs and benefits imposed by
its rules. We recognize that if adopted, the proposed new rule and rule
amendments would result in costs for some funds and other marketplace
participants.\441\ We have identified certain costs and benefits of the
proposed rule and rule amendments and request comment on all aspects of
this cost-benefit analysis, including identification and assessment of
any costs and benefits not discussed in this analysis. We seek comment
and data on our estimates of the costs and benefits identified. We also
welcome comments on the accuracy of the cost estimates in each section
of this analysis, and request that commenters provide data that may be
relevant to these cost estimates. In addition, we seek estimates and
views regarding these costs and benefits for funds and their
intermediaries, including small entities, and for investors, as well as
any other costs or benefits that may result from the adoption of the
proposed rule and rule and form amendments.
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\441\ Although we discuss many of these costs in terms of the
fund, the preparation of these reports is most likely done by
employees of the fund's adviser, because most funds do not have any
employees of their own.
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The proposal is designed to protect individual investors from
paying disproportionate amounts of sales charges in certain share
classes, promote 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. As discussed in greater detail above, we
are proposing to: (i) Rescind rule 12b-1 under the Act; (ii) adopt new
rule 12b-2 under the Act, which would permit funds to deduct a
marketing and service fee at a rate no greater than the maximum rate
permitted as a service fee under the NASD sales charge rule (currently
25 basis points) annually; (iii) adopt amendments to rule 6c-10, which
would permit funds to deduct asset-based sales charges in excess of the
marketing and service fee in the form of an ``ongoing sales charge''
(up to certain limits); (iv) as an alternative to the ongoing sales
charge, provide an elective alternative that would allow funds to sell
their shares through intermediaries subject to competition in
establishing sales charge rates; (v) amend Form N-1A and N-3 under the
Securities Act and the Investment Company Act, and Schedule 14A under
the Exchange Act to reflect the proposed rule and rule amendments, (vi)
make conforming amendments to rule 11a-3 under the Investment Company
Act; and (vii) make technical amendments to rules 17a-8, 17d-3, and
18f-3, and Forms N-SAR, N-4 and N-6 under the Investment Company Act,
and rule 6-07 of Regulation S-X under the Securities Act.
In general, for each aspect of the proposal, we have attempted to
estimate the potential costs and benefits in dollars for each entity
that may be affected. Some of the expected costs and benefits from our
proposals cannot be measured in dollars, but are effects nonetheless,
such as the benefits of improved investor understanding of distribution
charges and the costs and benefits of greater equity in the cumulative
amount of sales charges paid by individual investors. When actual
dollar costs and benefits would likely result (such as from the
elimination of certain disclosure requirements that would be eliminated
under the proposal, such as descriptions of 12b-1 plans) we have
estimated the relevant costs and savings.\442\
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\442\ We have discussed many of the benefits of this proposal
previously in this Release, and therefore, we will focus more on the
proposal's costs in this section, and will refer back to previous
discussions of our proposal's anticipated benefits when appropriate.
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In this analysis, Commission staff has estimated the percentage of
funds or other parties that are likely to change their operations in
response to our proposal. These and other estimates and assumptions are
based on interviews with representatives of funds, their
intermediaries, investor advocates, and the experience of Commission
staff. In addition, in preparing this cost-benefit analysis, Commission
staff reviewed fund prospectuses, periodic reports made to the
Commission pursuant to Form N-SAR and other fund filings, and a
commercial database of information on funds.\443\ Throughout this
analysis, unless otherwise stated, the estimates are based on these
interviews, reviews, and examinations.
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\443\ The Commission staff's review is based in part on
information obtained from Lipper's LANA Database.
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B. Impact of the Proposal
We have designed our proposal to minimize the cost impact on funds,
[[Page 47110]]
intermediaries, and service providers while maximizing the investor
protection and other benefits. As further discussed below, the staff
anticipates that funds representing approximately 93% of all assets
under management will incur minor or no expenses in complying with our
proposal. This section contains some basic estimates about the size of
the fund marketplace and its use of 12b-1 fees, and a general outline
of what we believe our proposal's impact will be on certain market
segments. Much of the information described in this section is included
in two tables at the end of this section. The information is based on
an analysis of data received on Form N-SAR and other filings and a
review of a Lipper database.
The staff estimates that as of the end of 2009, there were
approximately 9427 funds (consisting of 8611 traditional mutual funds
and 816 ETFs) sponsored by 682 investment advisers.\444\ Approximately
7367 of these funds have adopted a 12b-1 plan for one or more of their
share classes.\445\ Assets managed by all funds, as of the end of 2009,
totaled approximately $12.2 trillion.\446\
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\444\ Like mutual funds, most ETFs are registered open-end
management investment companies (a small number of ETFs are UITs).
However, ETFs are counted separately from mutual funds in ICI
statistics. The number of funds above reflects each separate series
of a fund (many funds consist of more than one series or portfolio).
Costs incurred in complying with the proposal may often be incurred
at the fund ``complex'' or ``family'' level, and not at the series
or class level, and, when appropriate, the staff has based its
estimates on the number of sponsors or families affected rather than
the number of series or classes.
\445\ A fund may have a 12b-1 plan, but not charge 12b-1 fees on
one or more particular share classes of the fund.
\446\ This figure is based on staff examination of industry
data, and includes traditional mutual funds, funds of funds, ETFs,
and funds underlying insurance company separate accounts.
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The number of sponsors is roughly equivalent to the number of
``fund families,'' which are groups of funds that share the same
investment adviser or principal underwriter and hold themselves out to
investors as related companies. Therefore, on average, each fund family
has approximately 14 funds.\447\ Of the 682 fund families, the staff
estimates that approximately 379 (or 56%) have at least one fund in the
family that currently has a 12b-1 plan. These fund families may be
affected in some way by our proposal. The staff estimates that 172 of
these 379 fund families (or 45%) only have funds that charge no more
than 25 basis points in 12b-1 fees, and the remaining 207 (or 55%) have
at least one fund that charges 12b-1 fees in excess of 25 basis points.
The 207 fund families that have at least one fund that charges 12b-1
fees in excess of 25 basis points average 37 funds per fund family, a
significantly higher average number of funds per family than the
typical fund family.\448\ As discussed previously, and in more detail
below, we anticipate that funds that charge 25 basis points or less in
12b-1 fees would incur minimal costs under our proposal, while those
that charge more than 25 basis points may be more significantly
affected by our proposal.
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\447\ This is based on the following calculation: (9427 funds /
682 advisers = 14 funds per adviser). This number can and does vary
widely, with some advisers managing only a single fund, and others
managing hundreds of funds.
\448\ The 207 advisers that advise at least one fund with a 12b-
1 fee in excess of 25 bps advise a total of 7660 funds, for an
average of 37 funds per family.
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The staff estimates that, as of the end of 2009, there were
approximately 26,788 fund share classes. On average, the staff
estimates that each mutual fund has approximately 3 share classes.\449\
However, some funds only have one share class (including many no-load
funds), while others may have ten or more classes to support a variety
of distribution arrangements.\450\ Generally, funds that charge 12b-1
fees tend to have more share classes, because they offer multiple
methods of paying for distribution (e.g., at the time of purchase, at
the time of redemption, or over time through the 12b-1 fee charged on
fund assets) for investors with different needs and goals.\451\ Thus,
for purposes of estimating costs per fund in this analysis, the staff
will assume that a typical fund that charges 12b-1 fees would have 4
classes: An A, B, and C share class, as well as an institutional or
retirement share class.\452\
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\449\ This is based on the following calculation: (26,788
classes / 8611 funds = 3 classes per fund). The staff excludes ETFs
from this calculation because most ETFs offer only one class of
shares, and therefore have reduced both the total fund and class
number by the number of ETFs in this calculation. An ETF that is
offered as a share class in a fund would be included in this
estimate of average share classes per fund.
\450\ See, e.g., Prospectus for The Growth Fund of America (Nov
1, 2009) (http://www.americanfunds.com/pdf/mfgepr-905_gfap.pdf).
\451\ Not all funds that charge 12b-1 fees offer multiple retail
classes. For example, the Legg Mason Funds only offer a single
retail class of shares for their funds, a C share equivalent that
charges 12b-1 fees without a front-end load. See, e.g., Prospectus
for Legg Mason American Leading Companies Value Trust (Aug 1, 2009),
(http://prospectus-express.newriver.com/get_template.asp?clientid=legg&fundid=52465Q101&level=4&doctype=pros).
\452\ See supra note 84. We do not expect that institutional
classes would be affected by our proposal because funds do not
typically charges 12b-1 fees on these classes.
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Of the 26,788 existing fund share classes, 12,646 (or 47% of all
classes) do not charge a 12b-1 fee. These classes hold approximately
$7.3 trillion in assets.\453\ The remaining 14,142 classes (or 53% of
all classes) that do charge a 12b-1 fee hold approximately $4.9
trillion in assets. The staff believes that 47% of fund classes (those
that do not charge 12b-1 fees) are unlikely to incur any costs as a
result of our rule proposal.\454\ Thus, the staff believes that funds
managing approximately $7.3 trillion in assets, representing 60% of all
assets under management, would not have to change their operations or
disclosures as a result of our proposal.\455\
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\453\ This figure is based on a staff examination of industry
data and includes mutual funds, funds of funds, ETFs, and funds
underlying insurance company separate accounts.
\454\ If our proposal is adopted, we do not expect that fund
classes that do not currently charge 12b-1 fees would begin charging
asset-based distribution fees, because the fund would have already
established a distribution structure and in light of the necessity
of obtaining shareholder approval to institute such a fee.
\455\ This figure is based on the following calculation: ($7.3
trillion (assets not subject to a 12b-1 fee) / $12.2 trillion (total
assets under management) = 60% of assets under management not
subject to a 12b-1 fee).
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A total of 6,482 share classes (or 46% of classes that charge 12b-1
fees) charge a 12b-1 fee of 25 basis points or less. As discussed
further below, although our proposal would affect these classes, we
anticipate that the funds with these classes are likely to incur
minimal costs associated with complying with our proposal. As a result,
the staff anticipates that of all 26,788 fund share classes, 19,128
(which hold $11.3 trillion in assets, representing approximately 93% of
all assets under management) would incur only minor, if any, costs if
our rule proposals are adopted.\456\
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\456\ As discussed further below, we recognize that the cost
impact of our proposal would not be distributed evenly across all
funds, but rather that certain funds and fund families are likely to
bear a greater share of the expenses that may result due to the
nature of their distribution and operational models.
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Approximately 7,660 (or 54%) of the share classes that have 12b-1
fees charge 12b-1 fees of greater than 25 basis points. All of these
classes would be affected in some way by our rule proposals. These
share classes hold approximately $855 billion in assets, or 17% of the
assets managed by classes that charge 12b-1 fees, and 7% of all assets
under management.
We request comment on these estimates.
[[Page 47111]]
[GRAPHIC] [TIFF OMITTED] TP04AU10.000
C. Marketing and Service Fee
Proposed rule 12b-2 would allow funds to deduct from fund assets a
marketing and service fee of up to the maximum rate of the service fee
permitted under NASD Conduct Rule 2830 (currently 0.25% or 25 basis
points of net fund assets annually).\457\ The proposed 25 basis point
marketing and service fee could be used for any legitimate distribution
related activity including, but not limited to, the continuing
shareholder account services encompassed by the NASD service fee.
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\457\ Proposed rule 12b-2(b); NASD Conduct Rule 2830(d)(5).
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1. Benefits
We anticipate that proposed rule 12b-2 would benefit investors by
permitting funds to continue to pay for: (i) Follow-up services
provided to investors 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 \458\ and retirement plans.\459\
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\458\ See supra Section III.C.
\459\ Because these payments represent an integral part of many
funds' distribution strategies, we believe that significantly
restricting the ability of funds to continue to pay for these
ongoing services through fund assets would likely disrupt existing
distribution systems, impose significant costs on funds and
intermediaries, and may have other unintended consequences that
could adversely affect funds and fund shareholders.
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We anticipate that our proposal would also benefit funds and their
directors, and ultimately fund shareholders, by eliminating the
procedural requirements of rule 12b-1. Under proposed rule 12b-2,
boards of directors of funds that deduct a marketing and service fee
would not be required to adopt a 12b-1 plan or annually approve it. As
a result, funds and their advisers would no longer incur many of the
costs of creating a 12b-1 plan, preparing quarterly and fiscal year
reports of plan expenditures, or preparing materials that support the
specific findings that fund boards are required to make annually in
order to approve a 12b-1 plan, as discussed in more detail in Section I
of this analysis.
As discussed above, fund boards would have discretion to use fund
assets to finance distribution activities within the limits of the rule
and their fiduciary obligations to the fund and fund shareholders.
Therefore, we anticipate that funds would still incur some costs
stemming from director review of arrangements paid for through the
marketing and service fee. Our understanding is that, in general, funds
pay their directors on an annual or per meeting basis, and we do not
expect that the directors will reduce the frequency of their meetings
as a result of the proposed marketing and service fee. Based on this
assumption, we estimate that funds that currently charge a 12b-1 fee of
25 basis points or less will likely not realize significant cost
savings as a benefit deriving from our proposal. However, the directors
of funds that impose a marketing and service fee
[[Page 47112]]
under proposed rule 12b-2 might spend less time on reviews and plan
approvals, and instead be able to focus more of their time on other
pressing concerns related to the fund's operations.\460\
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\460\ We discuss the cost savings that might result from the
proposed rescission of rule 12b-1 and its attendant director duties
in Section V.I of this Release, infra.
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2. Costs
We anticipate that funds that currently charge a 12b-1 fee of 25
basis points or less would not change the amount that they currently
charge under proposed rule 12b-2. The proposed maximum amount of the
marketing and service fee would be the same as the current NASD limit
on service fees, and would also be the same as the current NASD limit
on the amount of asset-based distribution fees that may be charged by
funds describing themselves as ``no-load.'' Thus, we expect that funds
that currently use 12b-1 fees for these purposes would continue to
charge the same level of fees. Because under the proposal, funds that
currently charge 12b-1 fees of 25 basis points or less could charge
marketing and service fees of the same or smaller amount without
holding a shareholder vote, we expect that funds that currently charge
12b-1 fees of 25 basis points or less would incur only the costs of
updating their disclosure documents as a result of our proposed
rulemaking.\461\
---------------------------------------------------------------------------
\461\ We estimate the costs of such disclosure changes in
Section V.G of this Release, infra.
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As discussed above, we do not anticipate that funds that currently
charge 25 basis points or less in 12b-1 fees would have to implement
any significant systems changes or incur other additional operational
costs in order to impose a marketing and service fee under proposed
rule 12b-2 because there should be no significant impact on operational
expenses due to a transition from a 12b-1 fee of that level to a
marketing and service fee. Nevertheless, directors and legal counsel to
these funds and their advisers may require some time and training to
review and understand the permissible uses and limits of marketing and
service fees, compared to current practices. Commission staff estimates
that for each fund family with one or more funds that charge a 12b-1
fee of 25 basis points or less, inside fund counsel would spend \462\
approximately 20 hours \463\ to review and understand the proposal and
the board of directors would spend approximately 3 hours \464\ to
review and understand their responsibilities under the proposal.
Because inside counsel and directors are typically not paid on an
hourly basis, and the staff does not expect that funds would hire
additional personnel or increase the frequency of meetings as a result
of this proposal, the staff does not anticipate that this process would
have any specific dollar costs for funds or advisers. However, we
recognize that this represents time that directors and counsel would
otherwise have spent on other fund business.
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\462\ Throughout this analysis we will estimate the cost of the
time spent by internal personnel in complying with the proposal,
because the time spent represents time that would otherwise be
available for other activities of the fund (or relevant entity).
Although these costs may be an economic cost of the proposal, it
would not result in new monetary costs for funds, and would not
result in the hiring of more staff by advisers or funds.
\463\ The staff estimates that the internal time cost equivalent
for time spent by internal counsel is $316 per hour, for a total
cost per fund family of $6320 (20 hours x 316 per hour = $6230).
This estimate of $316 per hour, as well as all other internal time
cost estimates made in this analysis (unless otherwise noted) is
derived from SIFMA's Management & Professional Earnings in the
Securities Industry 2009, modified by Commission staff to account
for an 1800-hour work-year and multiplied by 5.35 to account for
bonuses, firm size, employee benefits and overhead or from SIFMA's
Office Salaries in the Securities Industry 2009, modified by
Commission staff to account for an 1800-hour work-year and
multiplied by 2.93 to account for bonuses, firm size, employee
benefits and overhead.
\464\ The staff estimates that the internal time cost equivalent
for time spent by the boards of directors as a whole is $4500 per
hour, for a total cost per fund family of $13,500 (3 hours x $4500
per hour = $13,500). The staff has estimated the average cost of
board of director time as $4500 per hour for the board as a whole,
based on information received from funds, intermediaries, and their
counsel.
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Based on these estimates, other than the costs of revising their
disclosure documents which we analyze later in the section on the
disclosure amendments, the staff expects that the 6482 fund classes
that currently charge 12b-1 fees of 25 basis points or less would incur
no new costs in complying with proposed rule 12b-2. The assets under
management of these classes represent approximately 82% of the total
assets under management that are currently subject to 12b-1 fees.
We request comment on these estimates and assumptions regarding the
costs of compliance with our proposal for funds that currently charge
12b-1 fees of 25 basis points or less.
Is the staff correct in estimating that, other than costs
to amend disclosure documents, these funds would incur no new dollar
costs in complying with this part of our proposal? Is the estimate
regarding time spent by inside counsel and directors reasonable? Would
funds hire additional personnel, or otherwise incur additional or
different costs or benefits than what we have estimated here?
D. Ongoing Sales Charge: Funds
The proposed amendments to rule 6c-10 would permit funds to deduct
asset-based distribution fees in excess of the marketing and service
fee in the form of an ongoing sales charge.\465\ Proposed rule 6c-10(b)
would limit ongoing sales charges to an amount that does not exceed the
amount of the highest front-end load that the investor would have paid
if he or she had invested in another class of shares in the same fund.
Funds could also comply with the proposed rule amendments by deducting
the ongoing sales charge only until the cumulative rates imposed on
each share purchase matches the maximum front-end load, or in some
circumstances, the maximum sales charge limit set forth in NASD Conduct
Rule 2830(d)(2)(A) (currently 6.25% of the amount invested). In effect,
the proposal would treat asset-based distribution fees in excess of the
marketing and service fee as a type of deferred sales load.
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\465\ For a complete discussion of the proposed ongoing sales
charge, see Section III.D, supra. All funds that charge an ongoing
sales charge would also incur the costs of implementing a marketing
and service fee pursuant to proposed rule 12b-2 as well, as
discussed in Section C above.
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1. Benefits
We believe that the ongoing sales charge proposal would create a
number of benefits, many of which are discussed above.\466\ The
proposed amendment would limit the cumulative ongoing sales charges
that may be imposed on a purchase of fund shares to a set ``reference
load'' (generally the highest front-end load charged on the fund's
class A shares). As a result, investors would have the benefit of
knowing, at the time of their purchase, either the maximum amount that
they would pay for distribution, or the maximum length of time ongoing
sales charges would be deducted. As a result, long-term shareholders
would be protected from paying disproportionate amounts of sales
charges in certain share classes, as is currently possible under rule
12b-1.\467\ Finally, the ongoing sales charge would also be clearly
identified and described in the fund prospectus and fee table, which
should increase
[[Page 47113]]
transparency and improve investor understanding of fees.
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\466\ See supra Section III.M.
\467\ See, e.g., Comment Letter of Bridgeway Funds, Inc. and
Bridgeway Capital Management, Inc. (July 19, 2007).
---------------------------------------------------------------------------
We believe that the ongoing sales charge proposal would also result
in benefits for funds and fund directors. Under our proposal, funds
would not have to adopt a ``plan'' in order to impose an ongoing sales
charge, and fund directors would not be required to undertake time-
consuming formal reviews and approvals of 12b-1 plans. Instead, funds
and their boards would consider ongoing sales charges as integral parts
of a fund's sales load structure and would review them under the same
procedures under which boards currently review and approve the fund's
underwriting contract. Boards could benefit from this to the extent it
permits them to focus more on the fund's distribution system as a
whole.
As a result of our proposal, funds may eventually incur lower
compliance costs in tracking the sales charge limits established by
NASD Conduct Rule 2830. As discussed previously, NASD Conduct Rule
2830(d)(2) imposes a complex, fund-level cap on the aggregate amount of
sales charges, including asset-based sales charges, that may be imposed
by funds sold by broker-dealer members. The investor-level cap on
ongoing sales charges created by our proposal would provide an
alternative means of ensuring that the NASD sales charge rule's maximum
sales charge limits are not circumvented through the use of asset-based
sales charges. If our proposal is adopted, FINRA may consider amending
(or interpreting), this provision to eliminate the need for funds to
track aggregate sales charges at the fund level.\468\
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\468\ See note 74 supra (discussing how rule 2830 provides a
``minimum standard,'' and does not prevent a fund from developing a
better method of tracking the loads paid by shareholders and
ensuring that they do not overpay).
---------------------------------------------------------------------------
If FINRA were to amend (or interpret) this provision of Rule 2830,
it could reduce compliance costs for these funds.\469\ The staff
estimates that funds currently spend $2000 in costs and 5 hours of
internal staff time tracking these caps annually for each class that
charges a 12b-1 fee in excess of 25 basis points. The costs are for
computer and software resources, outside accountants, and other
compliance costs. The 5 hours of internal time spent by these funds
include 4 hours of time spent by accountants (at a cost of $153 per
hour) and 1 hour spent by an assistant compliance director (at a cost
of $326 per hour), for a total internal time cost equivalent of $938
per fund class.\470\ As discussed above, approximately 7660 classes
charge a 12b-1 fee in excess of 25 basis points, and we estimate that
approximately 50% of these (or 3830 classes) may no longer need to
incur these expenses. Therefore, the staff estimates a potential total
annual cost savings of $7,660,000 and a time savings of 19,150 hours
(representing an internal time cost equivalent of $3,592,540) \471\ for
this portion of the proposal for all funds.
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\469\ Funds that continue to have shares in classes with
grandfathered 12b-1 fees pursuant to proposed rule 12b-2(d) would
continue to incur these costs, however, during the grandfathering
period.
\470\ This estimate is based on the following calculations:
($153 x 4 hours = $612; $612 + $326 = $938).
\471\ This is based on the following calculation: ($938 x 3830
classes = $3,592,540 time savings value; 5 hours x 3830 classes =
19,150; $2,000 x 3830 classes = $7,660,000 cost savings).
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We request comment on these estimates and assumptions.
We considered several alternative methods of achieving the goals of
this rulemaking, including potentially requiring individual shareholder
level accounting of asset-based distribution fees, and prohibiting the
deduction of asset-based distribution fees entirely. Although these
alternatives might result in some of the benefits of the ongoing sales
charge proposal, we expect they would come at a significant cost. Our
proposal for an ongoing sales charge instead is designed to provide
many of these benefits to investors, without significantly disrupting
current distribution models or requiring most funds and intermediaries
to develop costly new operating systems.
2. Costs
If adopted, the limitations on ongoing sales charges contained in
proposed rule 6c-10(b) would require funds that currently charge 12b-1
fees in excess of 25 basis points to amend their share classes and/or
alter their operations in one of several ways. First, some funds may
choose to amend their share classes so that they conform to the new
requirements (e.g., by reducing their fees to a level that would not
implicate the ongoing sales charge limitations). Second, other funds
might restructure their expenses and separate non-distribution related
expenses from their asset-based distribution fees in order to keep
total fees from exceeding 25 basis points. Third, some funds might keep
their present share classes, but issue new shares that comply with the
proposed rule amendments after a certain date (i.e., ``old'' and
``new'' shares would be mixed in the same class). Fourth, other funds
might create new share classes on or before the compliance date that
meet the proposal's requirements. The chosen method of complying with
the new requirements would likely be driven by the fund's business
model and the cost-effectiveness of each option given the fund's
particular circumstances. In general, the staff assumes that either
funds or their advisers or other service providers would bear the costs
of implementing these changes.\472\ The costs of each of these
potential compliance options are discussed below.
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\472\ Fund families are organized in many ways, with some having
affiliated transfer agents, underwriters and other service
providers, and others contracting these services out to unaffiliated
third parties. The staff understands that some contracts obligate
the fund to reimburse the transfer agent for system costs related to
regulatory changes, while other contracts require the transfer agent
to bear these expenses. Because of the variability in these contract
terms, throughout this analysis, when the staff estimates costs, the
staff generally assumes that the estimated costs would be borne
directly by the affiliated service providers and the fund family, or
indirectly through increased expenses charged by unaffiliated
service providers. Except in the case of retirement plan record
keepers, who may face unique issues in responding to this proposal,
the staff does not break these costs out separately.
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a. Fee Reductions
Funds with classes that currently charge 12b-1 fees of more than 25
basis points might determine that it would be cost effective to reduce
their asset-based distribution fees to the 25 basis point cap of the
marketing and service fee. Funds could accomplish this by either
reducing their distribution expenses or shifting a portion of the costs
to their adviser or another party. These funds could continue offering
their existing share classes without having to provide for a conversion
period under proposed rule 6c-10(b).
We anticipate that, out of the funds that charge a 12b-1 fee of
more than 25 basis points, only those funds that charge up to 30 basis
points would likely reduce their asset-based distribution fee to 25
basis points or less. We expect that funds that charge more than 30
basis points would be unlikely to find the reduction to 25 basis points
or less to be the most cost effective means of complying with our
proposal, and therefore would be unlikely to pursue this alternative.
Commission staff estimates that there are approximately 471 fund
classes that charge 12b-1 fees of more than 25 up to and including 30
basis points (representing $143 billion in assets), and that 40% of
these classes (188) may reduce their fees to 25 basis points or less in
response to our proposal. The average class that charges 12b-1 fees in
this range has approximately $304 million in assets. If a class with
$304 million in assets that charged 30 basis
[[Page 47114]]
points reduced its 12b-1 fees to 25 basis points, investors in that
class would see their 12b-1 fees reduced by approximately $152,000
annually. If all of the classes that chose to reduce their fees charged
the full 30 basis points, the maximum fee reduction would be
approximately $28,576,000 a year.\473\
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\473\ This estimate is based on the following calculation:
($152,000 x 188 classes = $28,576,000).
---------------------------------------------------------------------------
These reductions in fees could be viewed as a cost to these funds
or their advisers. Nonetheless, investors in the funds would experience
a corresponding and offsetting dollar-for-dollar benefit due to lower
expenses. In any event, a fund likely would only elect this alternative
if it determined that the reduction would be cost effective. We request
comment as to the likelihood that funds would respond to our proposal
with fee reductions.
Are we correct in assuming that only funds that charge
between 25 and 30 basis points are likely to reduce their fees? How
many funds would choose this option? What kind of costs would they or
their affiliates bear to reduce their current 12b-1 fee, if any?
b. Fee Restructuring
Many funds currently pay for expenses that are not distribution
related with 12b-1 fees (such as administrative, sub-transfer agency,
or other fees). As a result, we expect that some funds with classes
that impose 12b-1 fees of more than 25 basis points, up to and
including 50 basis points (e.g., some A and R share classes), might
instead be able to treat the amount greater than 25 basis points as a
fund operating expense. These funds would have to carefully examine
their 12b-1 fees and identify which, if any, expenses could be properly
classified as non-distribution expenses. If non-distribution expenses
paid through 12b-1 plans are significant enough, these funds might be
able to reduce their asset-based distribution fees to the 25 basis
point cap and avoid being subject to the ongoing sales charge limits
and conversion periods in proposed rule 6c-10(b).
The staff estimates that there are approximately 2168 fund classes
that charge 12b-1 fees of more than 25 up to and including 50 basis
points. The staff previously estimated that approximately 188 of these
classes may respond by reducing their fees, leaving a total of 1980
classes that fall into this category. Of those classes, the staff
estimates that approximately 50% (or 990 classes) may be able, and find
it cost effective, to re-characterize a portion of their current 12b-1
fee.
We expect that funds that choose this course of action would incur
the costs of: (i) Conducting an internal review of the fees and
expenses charged by the affected share classes; (ii) amending fund
prospectuses and disclosure documents to reflect the fee re-structuring
(as discussed in greater detail below); and (iii) modifying operational
and accounting systems to reflect the restructured fees. The staff
estimates that it would take approximately 20 hours of inside counsel
time (at an internal time cost equivalent of $316 per hour), and 1 hour
of time for each board as a whole (at an internal time cost equivalent
of $4500 per hour), for a total internal time cost equivalent of
$10,820 to complete these tasks for each class.\474\ The staff
estimates that funds may incur an additional $5,000 in outside counsel
expenses associated with the internal review and disclosure
changes.\475\
---------------------------------------------------------------------------
\474\ This is based on the following calculations: ($316 x 20 =
$6320); ($6320 + $4500 = $10,820).
\475\ Any operational and accounting system costs would be
likely made at the fund family level, and are included in the
staff's estimated costs for fund families complying with the ongoing
sales charge proposal, as discussed below.
---------------------------------------------------------------------------
Therefore, we estimate that it would cost the 990 fund classes that
might perform this internal review and re-assessment of expenses
approximately $4,950,000 in outside expenses and $10,711,800 in
internal time cost equivalent to comply with our proposal.\476\ We
assume that the other 990 fund classes that charge between 25 and 50
basis points in 12b-1 fees, but do not re-assess these fees or
otherwise reduce their fees to 25 basis points or less, would impose an
ongoing sales charge in compliance with proposed rule 6c-10(b). Their
costs are discussed below.
---------------------------------------------------------------------------
\476\ This estimate is based on the following calculations:
($5000 per class x 990 classes = $4,950,000 total expenses);
($10,820 per class x 990 classes = $10,711,800 total internal time
cost equivalent).
---------------------------------------------------------------------------
We request comment on these estimates and assumptions.
Is the staff's estimate of $5,000 per fund class for
outside counsel expenses, 20 hours of inside counsel time, and 1 hour
of board time reasonable for the internal review and disclosure
amendment process? If not, what would be a better estimate? Are there
other costs that might be associated with such a review?
c. Ongoing Sales Charge: Conversion and Modified Share Classes
Under our proposed amendments to rule 6c-10, funds with asset-based
distribution fees in excess of 25 basis points (i.e. with ongoing sales
charges) that issue new shares after the compliance date, must have, or
create, a share class that does not impose an ongoing sales charge
(such as a typical class A) into which shares with the ongoing sales
charge would convert after a set period of time (a ``target
class'').\477\ We anticipate that there would be two primary sets of
costs that these fund families may incur related to our proposed
amendments to rule 6c-10: (i) Updating or creating a conversion system,
and (ii) amending or creating new share classes. Both sets of costs
would include expenses related to building or enhancing systems and
back office technology and operations.
---------------------------------------------------------------------------
\477\ See supra Section III.D for a further discussion of the
operation of the proposed rule.
---------------------------------------------------------------------------
(i) Conversion System
As a preliminary matter, the staff estimates that approximately 90%
(or 186) of the 207 fund families \478\ that may be affected by our
proposed amendments to rule 6c-10 have at least one fund with a class
of B shares and, as a result, have a conversion system in place that
they could use to convert shares with ongoing sales charges. The staff
estimates that it may cost a fund family $100,000 in one time initial
costs, and $50,000 annually, to modify an existing B share conversion
system to manage the conversions of funds with ongoing sales charges.
These costs would include: (i) Computer hardware needed to store an
increased volume of transaction activity; (ii) computer software to
expand and update the systems' ability to track share lots and convert
the shares based on the new aging schedules; and (iii) expanding back
office and accounting operations and hiring and training additional
back office personnel.
---------------------------------------------------------------------------
\478\ As we have discussed previously, a number of funds may
avoid these costs by reducing their asset-based distribution fees or
by re-characterizing expenses. Although some funds in a family may
be able to avoid such costs, it may be that only a few funds in the
family could do so, and therefore the fund family as a whole would
still incur these costs of complying with this part of our proposal.
The staff has therefore chosen to be conservative and include all
fund families that might be affected by the ongoing sales charge
proposal in the cost estimates below.
---------------------------------------------------------------------------
The other 10% or 21 fund families that do not have conversion
systems may incur additional costs to create a conversion system, or
contract for one through an external service provider. The staff
estimates that it would cost a fund family (or its affiliated transfer
agent) approximately $250,000 in initial costs and $100,000 in annual
costs to purchase or create a conversion system, integrate existing
computers, software, and networks, train personnel, and
[[Page 47115]]
update records. The staff estimates it would cost approximately the
same amount to outsource this type of system to an outside vendor.
Because a fund family's class structure generally is intimately tied to
its conversion system, as discussed below, we expect that the decision
to amend or create new share classes would be made in coordination with
any changes to the conversion system.
(ii) Operational Changes and Modified Share Classes
Next, we describe four potential routes that we believe fund
families could use to come into compliance with our proposed amendments
to rule 6c-10. In addition, we describe the staff's estimates of the
number of fund families that may use each route and the potential
costs. These routes include: (1) Retaining existing share class
structures and conversion systems; (2) updating the fund family's
existing conversion system and amending the class structure; (3)
updating the fund family's existing conversion system, amending the
class structure, and creating new share classes; and (4) creating/
purchasing a new conversion system, amending the class structure, and
creating new share classes. Because these routes are general paths to
compliance with our proposed amendments to rule 6c-10, we expect that
the experience of each fund family would likely vary significantly from
the average costs outlined below. In addition, some fund families may
need to ``mix and match'' parts of these outlined routes to meet the
particular needs of each fund within the fund family. However, we would
expect that affected fund families would generally comply with the
proposed amendments in one of the ways described above.
Funds would also have a variety of choices in managing shares with
12b-1 fees that have been grandfathered pursuant to proposed rule 12b-
2(d). Some fund families may choose to retain grandfathered 12b-1 share
classes for the period allowed, and amend those classes so that future
share purchases comply with the proposed amendment to rule 6c-10
(essentially mixing shares with differing conversion dates in the same
class), and then converting or exchanging the grandfathered shares into
the amended classes after five years. Other fund families may decide
not to grandfather 12b-1 shares and instead amend their existing
classes to fully comply with the proposed amendments to rule 6c-10 for
both new and existing shareholders (effectively applying the
requirements of the proposal to existing shares and not taking
advantage of the grandfathering provisions of proposed rule 12b-2(d)).
Finally, some funds may choose to manage grandfathered shares by
leaving those assets in existing classes for the period allowed, and
creating new share classes for all future share purchases, and then
converting or exchanging the grandfathered shares into the new classes
after five years. In any event, we anticipate that fund families would
choose the method that is most cost-effective and is in the best
interest of the fund family and its shareholders. The method of
managing share classes with grandfathered 12b-1 fees selected by the
fund family is likely to influence the route that the fund family would
select in complying with our proposed amendments to rule 6c-10(b), and
we have included the costs of managing share classes with grandfathered
fees in the staff's estimates below.\479\
---------------------------------------------------------------------------
\479\ Funds that amend or update existing share classes as a
result of our proposal would provide notification to their existing
shareholders. If the proposal is adopted, we anticipate providing a
transition period of at least 18 months, which should allow most
funds to provide this notification in their next regularly scheduled
prospectus update, or in an annual or semi-annual report. In some
cases, due to timing constraints, a fund may determine that it needs
to ``sticker'' its registration statement and inform its
shareholders of the share class changes in a separate and
unscheduled communication. These funds would incur additional costs.
---------------------------------------------------------------------------
Route 1: Retain Existing Share Class Structure and Conversion Systems
A fund family that sells funds with an existing class structure
that already generally complies with our proposed amendments to rule
6c-10 might only need to make minor changes to its operations in
response to our proposal. A fund family that does not sell C shares,
sells B shares that convert at a time that is consistent with proposed
rule 6c-10(b), and has a target class for converted shares (i.e., a
class that deducts 25 basis points or less in asset-based distribution
fees), would be included in this category.\480\ The costs and time
expended by such a fund family to comply with the proposed amendments
to rule 6c-10 would include: Reviewing the requirements of the rule (if
adopted); updating fund prospectuses, SAIs, and shareholder reports to
reflect the changed terminology and function of the two new types of
asset-based distribution fees; reviewing and making any necessary
updates to compliance policies and procedures; hiring outside counsel
to perform these reviews and updates; and providing training to
relevant internal personnel (i.e., staff from the fund, adviser, or
underwriter).
---------------------------------------------------------------------------
\480\ Such a fund would be unlikely to incur any costs relating
to managing shares with grandfathered 12b-1 fees because its
existing class structure would already be in compliance with our
proposed amendments and, thus, it would not need to maintain
separate classes for shares with grandfathered 12b-1 fees.
---------------------------------------------------------------------------
The staff estimates that approximately 15% (or 28) of the 186 fund
families that may be affected would be able to comply with the proposal
by making these minor changes to their operations. The staff estimates
that fund families that would make these operational changes would
incur approximately $20,000 in one-time costs, and 100 hours of time
expended by internal personnel to implement these changes for the
entire fund family. The staff estimates that the 100 hours spent by
internal personnel would break down as follows: 50 hours spent by
accountants and other back office personnel at $153 per hour; 30 hours
spent by programmers and other IT personnel at $190 per hour; 18 hours
spent by internal counsel at $316 per hour; and 2 hours spent by the
board of directors at $4500 per hour, for a total internal time cost
equivalent of $28,038.\481\ The staff therefore estimates that the
total costs for all affected fund families that use this route would be
$560,000 in one-time costs and 2800 hours of internal personnel time
expended at a total internal time cost equivalent of $785,064.\482\
---------------------------------------------------------------------------
\481\ These figures are based on the following calculations: (50
hours x $153 = $7650); (30 hours x $190 = $5700); (18 hours x $316 =
$5688); (2 hours x $4500 = $9000); ($7650 + $5700 + $5688 + $9000 =
$28,038 total internal time cost equivalent).
\482\ These figures are based on the following calculations:
($20,000 costs x 28 fund families = $560,000); (100 hours x 28 fund
families = 2800); ($28,038 x 28 fund families = $785,064).
---------------------------------------------------------------------------
We request comment on these estimates and assumptions.
Route 2: Update Conversion System and Make Amendments to Class
Structure
Alternatively, funds might need to make amendments to their
existing share classes to comply with our proposal.\483\ These funds
may need to change the conversion period of their class B shares,
institute a conversion period for class C shares, or make other changes
to their class structure. However, the staff assumes that fund families
that choose this route would not need to create new share classes,
because they would already have a target class for conversions that
meets the requirements of proposed rule 6c-10(b) (e.g., an existing
share class with
[[Page 47116]]
12b-1 fees of 25 basis points or less). The staff expects that these
fund families would not choose to create new share classes for
purchases made after the compliance date of the proposal (if adopted),
but would instead amend their existing classes.\484\ These fund
families would also have to update their conversion systems, at a
previously estimated one-time cost of $100,000 and $50,000 annually.
The staff estimates that approximately 50% (or 93) of the 186 fund
families that may be affected would need to amend their existing share
classes as a result of our proposal. The staff estimates that, on
average, each fund that amends its share classes would need to amend an
average of two share classes. The staff estimates that it would
typically cost approximately $10,000 and 25 hours of internal personnel
time to amend a share class to meet the requirements of our proposed
amendments to rule 6c-10.
---------------------------------------------------------------------------
\483\ Pursuant to rule 18f-3, fund share classes are required to
be organized according to a written plan that is approved by the
fund's directors, and thus this plan must be amended when changes
are made to a share class.
\484\ Instead, they would either amend existing classes to mix
grandfathered 12b-1 fee shares with new purchases with differing
conversion dates, or would not grandfather existing 12b-1 fees. In
either case, these funds would amend existing share classes, but
would not create new ones. The costs for funds that choose to create
new share classes as a means of managing share classes with
grandfathered 12b-1 fees or in response to our proposed amendments
to rule 6c-10 are described in our discussion of route 3, below.
---------------------------------------------------------------------------
However, the staff expects that most fund families would amend all
of the relevant share classes at the same time as part of a coordinated
plan for compliance with the proposed rules, and therefore should be
able to achieve significant economies of scale. Much of the work
involved in amending one share class is similar to that involved in
amending other classes, and if all amendments are undertaken at the
same time, significant efficiencies and elimination of duplicative
effort should result. The staff therefore estimates that a fund family
with 35 funds (the average for fund families that have at least one
fund with 12b-1 fees in excess of 25 basis points) would incur a total
of $100,000 in outside expenses and 250 hours of internal personnel
time expended. The time would represent approximately 140 hours spent
by accountants and other back office personnel at a rate of $153 per
hour, 100 hours spent by inside counsel at a rate of $316 per hour, and
10 hours spent by the board of directors as a whole, at a rate of $4500
per hour, for a total internal time cost equivalent of $98,020.\485\
---------------------------------------------------------------------------
\485\ These figures are based on the following calculations:
($153 x 140 hours = $21,420); ($316 x 100 hours = $31,600); ($4500 x
10 hours = $45,000); ($21,420 + $31,600 + $45,000 = $98,020).
---------------------------------------------------------------------------
These costs and time expenditures would include internal staffing
and outside counsel review to establish the amended terms of the class,
creating and/or amending relevant disclosure documents, amending the
written plan setting forth the terms of the funds' class structure,
holding a director vote on the class plan if necessary, any training
expenses, costs related to amending distribution or underwriting
agreements, and any costs related to altering the terms of the class on
the fund or its transfer agent's systems, the costs of exchanging or
converting remaining grandfathered shares into appropriate share
classes after the expiration of the grandfathering period, as well as
the costs of updating the fund family's operations discussed
above.\486\ The staff assumes that the costs of maintaining these
amended share classes would be the same as the cost of maintaining
current share classes, and therefore the staff estimates that funds
that choose this option would incur no additional ongoing annual cost
burden.
---------------------------------------------------------------------------
\486\ The costs of amending the fund family's operations, as
discussed above under route 1, is included in this estimate.
---------------------------------------------------------------------------
Therefore, the staff estimates that each fund family would incur
$100,000 in costs and 250 hours in internal personnel time (at an
internal time cost equivalent of $98,020) to amend their share classes,
and an additional $100,000 in one-time costs and $50,000 in annual
costs to update their conversion systems, for a total one-time cost of
$200,000, annual costs of $50,000, and 250 hours of time expended for
each of these fund families to comply with the ongoing sales charge
portion of our proposal. Based on these estimates, the staff further
estimates that all 93 potentially affected fund families that may
choose this option would incur a total of $18,600,000 in one-time
costs, $4,650,000 annually, and 23,250 hours in one-time internal
personnel time expended at an internal time cost equivalent of
$9,115,860.\487\
---------------------------------------------------------------------------
\487\ These figures are based on the following calculations:
($200,000 one-time costs x 93 fund families = $18,600,000); ($50,000
annually x 93 fund families = $4,650,000); (250 hours x 93 fund
families = 23,250 hours); ($98,020 x 93 fund families = $9,115,860).
---------------------------------------------------------------------------
We request comment on these estimates and assumptions.
Route 3: Update Conversion System, Make Significant Changes to Class
Structure, and Create New Share Classes
Other fund families may need to create new share classes to comply
with our proposed amendments to rule 6c-10. These fund families might
need to create new share classes either because they do not have an
appropriate target class for conversions (for example, if their class A
shares deduct more than 25 basis points in asset-based distribution
fees), or if they chose to maintain grandfathered 12b-1 assets in
existing share classes and create new share classes for all future
share purchases after the compliance date of the rule (if
adopted).\488\ In addition to creating new share classes, these fund
families would also likely need to amend their existing share classes.
These fund families would also need to update their conversion systems,
at a previously estimated one-time cost of $100,000, and $50,000
annually.\489\
---------------------------------------------------------------------------
\488\ For example, a fund might have a class A that deducts 35
basis points in asset-based distribution fees, class B shares that
convert at a date later than the proposal would require, and class C
shares that do not convert. This fund might need to create a new
class A that deducts 25 basis points or less as a target class for
conversions, and if the fund chose to maintain grandfathered assets
in the existing A and C shares classes, might also create a new
class A and C that meets the terms of the proposal. In addition, the
fund may choose to amend the conversion requirements of the class B
shares to comply with the requirements of the proposal for both new
and existing shareholders (``mixing'' conversion dates in the same
class). This fund would be creating three new share classes and
amending one other class.
\489\ See supra Section V.D.2.c.(i).
---------------------------------------------------------------------------
The staff estimates that the remaining 35% (or 65) of 186
potentially affected fund families with conversion systems would create
new share classes in response to our proposed amendments to rule 6c-10.
The staff estimates that it would cost each fund approximately $100,000
and 100 hours of internal personnel time to create a new share
class.\490\ These expenses would include internal staffing and outside
counsel involvement to establish the terms of the new class, create
and/or amend relevant disclosure documents, amend the written plan
setting forth the terms of the funds' class structure, hold a director
vote if necessary, any training expenses, the costs of amending
distribution and underwriting agreements, the costs of exchanging or
converting remaining grandfathered shares into appropriate share
classes after the expiration of the grandfathering period, any costs
related to implementing the new class on the fund's or transfer agent's
systems, and any costs related to updating the fund's operations
discussed above. The staff's estimate assumes that the costs of
maintaining these new share classes would be the same as the costs of
maintaining current share classes, and the staff estimates that funds
that choose
[[Page 47117]]
this option would incur no additional ongoing annual cost burden
related to the class structure changes. The staff estimates that, on
average, each fund that creates new share classes would need to create
two new share classes and amend one additional share class (at the same
cost as amending share classes discussed above).
---------------------------------------------------------------------------
\490\ As discussed below, funds that choose this option would
likely achieve significant cost savings and economies of scale by
creating all new classes simultaneously. To be conservative,
however, Commission staff has also estimated the costs of creating
each class individually.
---------------------------------------------------------------------------
However, as discussed previously, the staff expects that most fund
families would make all necessary changes to their distribution
structure as part of a coordinated plan for compliance with the
proposed rules, and therefore should be able to achieve significant
economies of scale and costs savings over the costs of amending or
creating a single share class. For example, often, a number of funds in
a family share a single prospectus, which could be amended at a single
time, and the class structure could be amended with a single director
vote. In light of these expected economies of scale, the staff
estimates that a typical fund family would incur $800,000 in costs and
500 hours in internal personnel time to create new share classes, and
$50,000 in costs and 100 hours in internal personnel time expended to
amend existing share classes, for a total of $850,000 in outside costs
and 600 hours of internal personnel time expended. The internal
personnel time expended would include approximately 200 hours spent by
programmers and other back office IT staff at a rate of $190 per hour,
200 hours spent by accountants at a rate of $153 per hour, 190 hours
spent by inside counsel at a rate of $316 per hour, and 10 hours spent
by the board of directors as a whole at $4500 per hour, for a total
internal time cost equivalent of $173,640.\491\ Including $100,000 in
one-time costs and $50,000 in annual costs to update their conversion
systems, the total cost for each fund family would be $950,000 in one-
time costs, $50,000 in annual costs and 600 hours expended.
---------------------------------------------------------------------------
\491\ These figures are based on the following calculations:
($190 x 200 hours = $38,000); ($153 x 200 hours = $30,600); ($316 x
190 hours = $60,040); ($4500 x 10 hours = $45,000); ($38,000 +
$30,600 + $60,040 + $45,000 = $173,640).
---------------------------------------------------------------------------
Based on these staff estimates, the 65 potentially affected fund
families would incur a total of $61,750,000 in one-time costs,
$3,250,000 in annual costs, and 39,000 hours in one-time internal
personnel time expended (at an internal time cost equivalent of
$11,286,600) to comply with our proposal.\492\
---------------------------------------------------------------------------
\492\ These figures are based on the following calculations:
($950,000 one-time costs x 65 fund families = $61,750,000); ($50,000
annually x 65 fund families = $3,250,000); (600 hours x 65 fund
families = 39,000 hours); ($173,640 x 65 fund families =
$11,286,600).
---------------------------------------------------------------------------
We request comment on these estimates and assumptions.
Route 4: Purchase New Conversion System, Make Significant Changes to
Class Structure, and Create New Share Classes
Finally, if our proposed amendments to rule 6c-10 are adopted, some
funds would have to purchase or create a conversion system. As
previously discussed, the staff estimates that 10% or 21 fund families
that may be affected by our proposed amendments to rule 6c-10 currently
do not have a conversion system, either because they only sell a single
class of shares, or if they sell multiple classes of shares, none of
their share classes has a conversion feature. The staff has previously
estimated that it would cost approximately $250,000 in initial costs
and $100,000 in annual costs to purchase or create a conversion system.
In addition to purchasing a new conversion system, these fund
families would also need to create a new target class for converted
shares and amend existing share classes to meet the requirements of our
proposed amendments to rule 6c-10. For example, if a fund sold only
class C shares that deducted asset-based distribution fees in excess of
25 basis points, the fund would need to create a new target class for
converted shares. In addition, if the fund chose to maintain
grandfathered 12b-1 assets in the existing class, the fund may need to
create a second class of shares for future purchases. On the other
hand, if the fund chose to dispense with grandfathering 12b-1 fees, it
might amend the existing C class so that it complied with our proposed
amendments to rule 6c-10 for both existing and new shareholders.
The staff has previously estimated that it may cost each fund
approximately $100,000 and 100 hours of internal personnel time to
create a new share class and $10,000 and 25 hours to amend a share
class. The staff assumes that each affected fund that does not
currently convert shares would have to create two new share classes and
amend one additional share class to meet the requirements of the
proposed amendments to rule 6c-10.
However, as discussed previously, the staff expects that most fund
families would make all necessary changes to their distribution
structure as part of a coordinated plan for compliance with the
proposed rules, and therefore should be able to achieve significant
economies of scale and costs savings over the costs of amending or
creating a single share class. In light of these expected economies of
scale, the staff estimates that each fund family would incur $800,000
in costs and 500 hours in internal personnel time to create new share
classes, and $50,000 in costs and 100 hours in internal personnel time
expended to amend existing share classes, for a total of $850,000 in
outside costs and 600 hours of internal personnel time expended. The
internal personnel time expended would include approximately 200 hours
spent by programmers and other back office IT staff at a rate of $190
per hour, 200 hours spent by accountants at a rate of $153 per hour,
190 hours spent by inside counsel at a rate of $316 per hour, and 10
hours spent by the board of directors as a whole at $4500 per hour, for
a total internal time cost equivalent of $173,640.\493\ Including
$250,000 in one-time costs and $100,000 in annual costs to purchase or
build a conversion system, the total cost for each fund family would be
$1,100,000 in one-time costs, $100,000 in annual costs and 600 hours
expended.
---------------------------------------------------------------------------
\493\ These figures are based on the following calculations:
($190 x 200 hours = $38,000); ($153 x 200 hours = $30,600); ($316 x
190 hours = $60,040); ($4500 x 10 hours = $45,000); ($38,000 +
$30,600 + $60,040 + $45,000 = $173,640).
---------------------------------------------------------------------------
Based on these staff estimates, the 21 potentially affected fund
families would incur a total of $23,100,000 in one-time costs,
$2,100,000 in annual costs, and 12,600 hours in one-time internal
personnel time expended (at an internal time cost equivalent of
$3,646,440) to comply with our proposal.\494\
---------------------------------------------------------------------------
\494\ These figures are based on the following calculations:
($1,100,000 one-time costs x 21 fund families = $23,100,000);
($100,000 annually x 21 fund families = $2,100,000); (600 hours x 21
fund families = 12,600 hours); ($173,640 x 21 fund families =
$3,646,440).
---------------------------------------------------------------------------
We request comment on these estimates and assumptions.
E. Ongoing Sales Charge: Investors
Investors currently appear to have difficulty understanding 12b-1
fees and the activities and services for which they are used.\495\ Our
proposal would differentiate between the two constituent parts of
current 12b-1 fees (asset-based sales charges and service fees). It
would allow funds to use a limited amount of assets as a marketing and
service fee, and deduct any excess amounts over the marketing and
service fee as an ongoing sales charge. The renamed fees would appear
separately in an amended fee table in the prospectus under the headings
``marketing and service fees'' and ``ongoing sales charge.''
---------------------------------------------------------------------------
\495\ See supra Section II.E.
---------------------------------------------------------------------------
[[Page 47118]]
By more clearly identifying the two types of asset-based
distribution fees, we expect that the proposal would make it easier for
investors to understand when they are paying a sales charge. In
addition, these proposed changes to the fee table and the revised
narrative disclosure in the prospectus should also help investors
better understand the services they are paying for through the
marketing and service fee and the ongoing sales charge. This improved
understanding should help investors more easily compare sales charges
in alternative share classes and competing funds and, therefore, choose
the sales charge option that best meets their investment needs. We
anticipate that this would lead investors to choose lower priced
offerings of funds or share classes that offer comparable services,
which should lead to greater price competition among funds and lower
sales charges.
Investors empowered with this information may invest differently.
Although we cannot predict investor behavior, we assume that if offered
lower prices for the same services, or provided with better information
regarding the distribution services received, many investors would
choose to move their investments to, or make new investments in, a fund
or share class with lower asset-based distribution fees or loads.
Conversely, investors may decide to avoid funds that charge high asset-
based distribution fees if they believe that they would not get, or
want, commensurate levels of service. We expect that investors who
choose to shift invested assets would only move assets that are not
subject to a CDSL, or on which they had not already paid a front-end
load. Thus, we do not anticipate that investors would shift assets
invested in class A or B shares if our proposal were adopted. In
addition, our proposal would require that assets held for long periods
of time in level load classes (for example, class C shares) eventually
convert to classes that do not deduct an ongoing sales charge, which
would result in a net movement of assets out of these level load
classes into lower cost classes.
Commission staff estimates that approximately $686 billion in total
net assets currently are invested in level load share classes, and that
approximately $3.4 billion in 12b-1 fees are deducted from these assets
fees annually, for an average 12b-1 fee as a percentage of total net
assets in these classes of 50 basis points.\496\ The staff further
estimates that if our proposed rule and disclosure amendments are
adopted, improved investor understanding of distribution related
charges would result in an aggregate total of between five and ten
percent of assets currently invested in level load classes (for
example, C shares) moving to share classes (within the same fund or in
a different fund) that do not deduct an asset-based distribution fee.
If five percent of the $686 billion in assets in these classes (or $34
billion) were moved to share classes without asset-based distribution
fees, at an annual 12b-1 fee rate of 50 basis points, investors would
save approximately $170 million annually.\497\ If ten percent of the
$686 billion in assets in these classes (or $68 billion) were moved to
share classes without asset-based distribution fees, investors would
save approximately $340 million annually.\498\ Over a ten-year period,
this would represent a potential savings of between $1.7 billion and
$3.4 billion to investors in asset-based distribution fees that they
would otherwise have paid, but would avoid because of better informed
decision making.
---------------------------------------------------------------------------
\496\ We recognize that some portion of the 50 basis points may
represent service fees and that an investor who shifts their assets
from a level load fund class may still select a fund class that
charges a service fee or a reduced ongoing sales charge. However,
for purposes of this analysis, the result of the staff's estimates
represent the total cumulative effect of all asset movement from
level load funds to no-load or lower load funds.
\497\ This estimate is based on the following calculation:
($34,000,000,000 x 0.005 = $170,000,000).
\498\ This estimate is based on the following calculation:
($68,000,000,000 x 0.005 = $340,000,000).
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If our proposal is adopted, we would provide a grandfathering
provision for current 12b-1 share classes for a five-year period.
However, at the end of that five-year period, all shares that are
currently subject to a 12b-1 plan would need to be converted or
exchanged into a class that does not deduct an ongoing sales charge and
with a marketing and service fee that is no higher than the 12b-1 fee
in effect in the previous fiscal year. This expiration of the
grandfathering period would effectively time limit level load share
classes as they exist today. All assets that remain in level load share
classes after the expiration of the grandfathering period would need to
be converted to a class that does not deduct an ongoing sales charge;
effectively a class that charges 25 basis points or less in asset-based
distribution fees. This conversion or exchange would benefit investors
who remained in these level load classes at the end of the
grandfathering period to the extent that the asset-based distribution
fees on the share class they are converted into is lower than the
current 12b-1 fee.
The staff estimated above that the average 12b-1 fee on level load
share classes is 50 basis points. Because no ongoing sales charge could
be charged on the converted or exchanged shares and the highest
marketing and service fee allowed under the proposal is 25 basis
points, the staff estimates that investors who remain in the
grandfathered 12b-1 share class would save 25 basis points a year after
the expiration of the grandfathering period. However, as discussed
above, the staff estimates that some investors may move their existing
level load assets to lower load classes as a result of this proposal,
and further reductions in the assets of existing level load share
classes may occur through redemptions or reduced investment. The staff
estimates that at the expiration of the grandfathering period in five
years, approximately 50% of the $686 billion (or $343 billion) in
existing level load share class assets will remain. Upon the conversion
or exchange of these assets into share classes that do not deduct an
ongoing sales charge, the staff estimates that investors in these
classes will save 25 basis points a year (the asset-based distribution
fees charged in excess of the amount permitted as a marketing and
service fee), or a total of $857,500,000 annually.\499\
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\499\ This estimate is based on the following calculation:
($343,000,000,000 x 0.0025 = $857,500,000).
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In addition, if our proposal is adopted, we estimate that net new
investments in level load fund classes would decline as investors
choose share classes with no or lower sales charges, whether in the
form of an asset-based distribution fee, front-end load or CDSL, and as
a result of requirements in the proposal to eventually convert shares
that charge an ongoing sales charge into a class that does not deduct
such a fee at a set time. The staff estimates net new investments in
level load fund classes may decline between ten and twenty percent as a
result of our proposal (with a commensurate increase in net new
investments in no or low load funds). Based on a review of Lipper's
LANA Database and data filed with the Commission, the staff estimates
that approximately $52 billion in net new cash flowed to level load
classes in 2009, with those level load classes charging an average
asset-based distribution fee of approximately 50 basis points. Assuming
that there would be similar net cash flow to these classes in future
years, if ten percent of the net new cash flow to level load classes
(or
[[Page 47119]]
$5.2 billion) is invested in classes that do not charge asset-based
distribution fees, Commission staff estimates that investors would save
approximately $26 million annually.\500\ If twenty percent of the net
new cash flow to these classes (or $10.4 billion) is instead invested
in classes that do not charge asset-based distribution fees, Commission
staff estimates that investors would save approximately $52 million
annually.\501\ Over a ten-year period, this represents potential
savings of between $260 million and $520 million for investors who
might be better served in other classes with a more appropriate level
of service for their needs or wants.
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\500\ This estimate is based on the following calculation:
($5,200,000,000 x .005 = $26,000,000).
\501\ This estimate is based on the following calculation:
($10,400,000,000 x .005 = $52,000,000).
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As discussed above, we expect that one result of our proposal would
be a net shift by investors to lower load share classes. As part of
this net shift, we would expect that some investors might determine
that they need or want continuing high levels of service, and may
choose to move their assets out of level load share classes and into
fee-based or wrap fee accounts, which may have higher expenses than the
level load share classes the investor had previously owned.\502\ These
investors may pay higher expenses as a result of this choice, but would
presumably also receive higher levels of service, and the ability to
trade between funds in different fund families without paying
additional loads. The proposal would provide investors with better
information regarding the asset-based distribution fees they pay, which
should enhance the ability of investors to select the type of account
or method of paying distribution fees that is best for them, even if
some investors choose to invest through more costly methods as a
result.
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\502\ Other investors, however, would move their assets into
lower cost funds, as discussed previously. Level-load share classes
typically deduct 100 basis points or less in asset-based
distribution fees annually. Fee-based or wrap accounts often charge
higher fees (between 100 and 200 basis points annually) but the
broker-dealers that offer wrap accounts also provide additional
services and transaction options for their clients.
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There is some question as to whether a reduction in asset-based
distribution fees paid by investors would be purely a benefit of the
proposal resulting from markets that are more efficient and investors
making better-informed investment choices, or whether it would
represent a transfer of assets from investment managers or broker-
dealers to investors. The goals of this rulemaking include providing
better and more transparent information to investors regarding the
asset-based distribution fees they pay, enabling investors to more
efficiently allocate their investments and meet their investment goals,
and promoting competitive markets. In light of these goals, we believe
that any reduction in asset-based distribution fees paid by investors
that is due to better-informed investment decisions made as a result of
this proposal should be counted as a benefit.
Do commenters agree that the estimated reductions in sales
charges investors would pay are a benefit of this proposal? We further
request comment on the estimates and assumptions we have made in this
section regarding the benefits of our proposal to investors and the
likelihood that a certain portion would invest in funds with lower
sales charges. In particular, we request comment on the quantitative
estimates the staff has made and request that commenters provide any
quantitative data they may have on the likely behavior of investors in
response to our proposals.
Currently, funds with class C shares typically do not charge a CDSL
after the first year, which allows the potential for some short-term
shareholders in C share classes to redeem soon after purchase and pay
less asset-based distribution fees compared to longer-term shareholders
in the same share class. Essentially, the longer-term C class
shareholders subsidize some of the distribution expenses of the
shorter-term shareholders. Funds typically structure their C shares in
this manner to attract investors who may not want to be committed to a
long-term investment in a fund, and who may pay significantly more or
less in distribution costs depending on how long they remain invested
in the fund. Funds also take the risk that the distribution expenses
associated with short-term investments in C shares will not be balanced
out by long-term C class shareholders who may pay significantly more in
asset-based distribution fees than if they had instead invested in some
other class.
Proposed new rule 12b-2 and amended rule 6c-10 would have the
effect of limiting the total asset-based distribution fees that long-
term shareholders would pay, and may thereby alter the economic
incentives involved in structuring a C share class without a CDSL. If
the proposal is adopted, some funds may reconsider the economics of C
share classes, and could restructure those classes, perhaps imposing a
CDSL similar to B share classes. If this occurs, this could effectively
eliminate the opportunity for some short-term C class shareholders to
avoid paying a portion of the distribution expenses associated with
their investment. However, it would also effectively eliminate the
potential for some longer-term shareholders in C classes to subsidize
those costs by paying significantly more in asset-based distribution
fees over time. One of the goals of this rulemaking is to help ensure
more equity between shareholders in the payment of fund distribution
expenses. However, we acknowledge that achieving this more equitable
treatment between shareholders may come at a cost to certain short-term
shareholders whose distribution expenses would no longer be subsidized
by long-term C class shareholders.
We request comment on the likelihood of funds restructuring their C
share classes as discussed above, and any potential impact such a
restructuring might have on both long- and short-term investors in
those classes.
In particular, we request comment on any quantitative
estimates of the amount of additional asset-based distribution fees
that short-term investors may pay and the amount of such fees that
long-term shareholders may save as a result of this proposal.
F. Ongoing Sales Charge: Intermediaries
Broker-dealers and other intermediaries may also be affected by the
proposed limitations on ongoing sales charges. Currently, FINRA rules
do not limit the total amount of asset-based sales charges that an
individual fund investor may pay. NASD Conduct Rule 2830 limits the
aggregate amount of these fees and other sales loads that a fund may
pay to its distributor, to a percentage of the amount of gross new
sales of fund shares. Because most funds continually sell new shares
(and thus have new sales), we understand that most funds do not reach
this limit. As a result, broker-dealers generally may receive asset-
based sales charges on an investment in fund shares for as long as the
investor holds the shares (or, in the case of B shares, until the
shares convert). The conversion requirements of our ongoing sales
charge proposal would limit the amount of asset-based distribution fees
that an individual investor would pay to an amount that is tied to the
front-end load of the fund, or the NASD sales charge limits.
Our proposed amendments to rule 6c-10 may have the effect of
reducing the total compensation that intermediaries receive from the
sale of certain types of shares (such as B, C, or R shares). However,
as discussed previously, any reduction in compensation would be
[[Page 47120]]
experienced as reduced costs for investors because distribution charges
that are not deducted from fund assets would be retained by
shareholders.
The amount of any reduction in intermediary compensation that might
result is speculative.\503\ For example, many class B shares currently
convert on a schedule that generally meets, or come close to meeting,
the requirements we propose today. Therefore, we anticipate that
complying with the proposal's requirements with respect to class B
shares would result in, at most, a minor reduction in compensation to
broker-dealers. Class C shares (which are generally described in fund
prospectuses as being suitable for short-term investments) do not
convert, but if they are sold as short-term investments, we believe
they generally would not be held long-term. Based on average holding
periods for funds generally, we expect that only a limited portion of
outstanding class C shares would be held long enough for any asset-
based distribution fees on class C shares to exceed the proposed
ongoing sales charge limit.\504\
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\503\ The staff has estimated some potential effects of our
rulemaking on investor behavior (and consequent reduction in
intermediary compensation) in Section V.E of this Release, supra.
\504\ Comprehensive data on the typical retention period for C
shares is not available, but the typical fund shareholder only holds
fund shares for approximately 3-4 years. Based on a front-end load
equal to 6%, a C share investor could pay an ongoing sales charge of
75 basis points for approximately 8 years before reaching the
ongoing sales charge limits we propose today. This holding period
would be more than double the typical holding period for all fund
shares, and particularly long for C shares, which funds disclose as
appropriate for short-term holding periods.
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Funds with class R shares or similar classes (which typically are
sold in tax-advantaged accounts and are intended as long-term
investments) may charge 12b-1 fees in amounts exceeding 25 basis points
that would become subject to the limitations on ongoing sales charges.
These share classes often use 12b-1 fees to pay for associated
recordkeeping and shareholder services, as well as for distribution
expenses. As we have discussed above, some funds may be in a position
to identify those non-distribution expenses and re-characterize them as
administrative fees, thereby avoiding the need to impose an ongoing
sales charge without reducing distribution payments to intermediaries.
To the extent that any portion of 12b-1 fees currently charged on class
R shares must be considered to be an ongoing sales charge, any estimate
reduction in compensation resulting from our proposal would be
speculative, because as discussed above, we anticipate that the lost
revenue may be recovered through other sources.\505\
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\505\ As discussed above, broker-dealers often receive payments
from fund advisers known as ``revenue sharing,'' which supplements
the compensation they receive for distributing fund shares. See
supra note 65.
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If intermediaries experience a significant reduction in
distribution compensation, would they be likely to renegotiate revenue
sharing agreements and recover some or all of the lost compensation
through these sources? Would intermediaries be likely to receive less
compensation based on the ongoing sales charge limits of our proposal?
How much less? Would they make up any or all of any such loss through
revenue sharing agreements? Do commenters believe that this reduction
in compensation should be treated as a cost of the proposal,
considering that any reduction would come with a corresponding increase
in the assets held by investors?
Intermediaries such as broker-dealers, banks, and insurance
companies may also incur costs in connection with our proposals.\506\
For example, these intermediaries may need to enter into new or amended
distribution agreements with the funds that they sell, enhance their
recordkeeping systems, update sales literature, and provide additional
training to their sales representatives regarding the new regulatory
framework for mutual fund asset-based distribution fees and the
suitability of different share classes for their clients. The staff
estimates that there are approximately 4,770 of these types of
intermediaries, and that approximately 40% of these intermediaries (or
1,908) receive 12b-1 fees, and therefore would be affected by our
proposal.\507\ The staff estimates that, on average, each affected
intermediary would expend $50,000 in costs and 100 hours of internal
personnel time in response to our proposals.\508\ This internal time
would include approximately 75 hours spent by professionals such as
compliance personnel at a rate of $210 \509\ per hour and 25 hours
spent by inside counsel at a rate of $316 per hour, at a total internal
time cost equivalent of $23,650.\510\ Therefore, the staff estimates
that all intermediaries may incur approximately $95,400,000 in one-time
costs and 190,800 hours (at an internal time cost equivalent of
$45,124,200 as a result of the proposed new rule and rule
amendments).\511\
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\506\ The costs for retirement plan record keepers are discussed
below, and the costs for transfer agents are included in the
previously discussed costs for mutual funds above.
\507\ This number consists of the following: 2,203 broker-
dealers classified as specialists in fund shares, 167 insurance
companies sponsoring registered separate accounts organized as unit
investment trusts, approximately 2,400 banks that sell funds or
variable annuities (the number of banks is likely over inclusive
because it may include a number of banks that do not sell registered
variable annuities or funds, or banks that do their business through
a registered broker-dealer on the same premises). This number may be
over or under inclusive, because the actual number of intermediaries
that would be affected would vary based on the intermediary's
business model and whether the intermediary sells funds that deduct
12b-1 fees.
\508\ We recognize that this average will likely vary
significantly, with large intermediaries incurring many times this
cost estimate and small intermediaries likely incurring far less.
\509\ The staff has based the hourly cost estimates for time
spent by intermediaries in this section on SIFMA's Management &
Professional Earnings in the Securities Industry 2009, supra note
407, because the staff believes the hourly costs are comparable.
\510\ These figures are based on the following calculations:
($210 x 75 hours = $15,750); ($316 x 25 hours = $7,900); ($15,750 +
$7,900 = $23,650).
\511\ These estimates are based on the following calculations:
(1,908 intermediaries x $50,000 = $95,400,000 in costs); (1,908
intermediaries x 100 hours = 190,800 hours expended); (1,908
intermediaries x $23,650 = $45,124,200).
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In addition, our proposal may require intermediaries such as
retirement plan administrators or other omnibus account record-keepers
to begin tracking share lots and managing share conversions. This
change may require these intermediaries to invest in new systems or
enhance their current recordkeeping and back office systems. If a
retirement plan offers fund classes that deduct an ongoing sales
charge, the proposal would require such shares purchased by plan
participants to eventually be converted to a class that does not deduct
an ongoing sales charge. This conversion requirement would create costs
for retirement plan record-keepers because we understand that
currently, most record-keepers do not maintain individual participant
share histories. Record-keepers for plans that offer shares classes
with an ongoing sales charge would need to begin tracking the date of
purchase of each share lot for each participant, and tie that share
history to the appropriate conversion date. In addition, plans
currently usually only have a single class of shares for each fund
offered within the plan. If our proposal is adopted, however, if the
single class that is offered within the plan deducts an ongoing sales
charge, a second class of shares for each fund (i.e. a target class for
converted shares) would have to be added to the record-keeper's
systems, effectively adding more complexity and costs to their
operations. For example, as a result of this increase in the number of
shares classes, record-keepers might
[[Page 47121]]
need to increase the size of their participant statements, spend more
time answering participant questions, process more trades, and manage
operational complexities related to multiple share classes (such as
allocating withdrawals between share classes for participant loans and
rebalancings, identifying the correct conversion date for reinvested
dividends, and other issues).
Only record-keepers that provide services to retirement plans that
offer fund share classes with 12b-1 fees in excess of 25 basis points
would be affected by our proposal.\512\ The staff estimates that there
are approximately 2,025 intermediaries that provide recordkeeping for
retirement plans, and that approximately 25% (or 506) of those record-
keepers provide services to plans that offer fund share classes with
12b-1 fees in excess of 25 basis points.\513\ The staff estimates that
approximately 35% (or 177) of the 506 affected record-keepers would
choose to upgrade their systems to manage ongoing sales charges, while
the other 65% (or 329) would choose to do business only with plans that
offer funds without an ongoing sales charge, and thus avoid the costs
discussed below.\514\ The staff estimates that it would cost a record-
keeper approximately $1,000,000 in one-time costs and $1,500,000
annually to manage ongoing sales charges for the plans they
service.\515\ These expenses would include, but not be limited to,
expenses related to enhancing computer software to begin tracking and
aging share histories and multiple share classes, additional computer
hardware and storage costs for the increased volume of information
related to participant positions, larger participant statements (and
higher mailing costs), increased time spent providing service to
participants, and costs related to managing the operational
complexities discussed above. Therefore, the staff estimates that
intermediaries that provide recordkeeping services to retirement plans
may incur a total one-time cost of $177,000,000 and an annual cost of
$265,500,000 in complying with our proposal.\516\
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\512\ Record-keepers for plans that only offer funds with 12b-1
fees of 25 basis points or less would be generally unaffected by our
proposal, because they would not need to change their systems to
manage the ongoing sales charge and its related multiple share
classes and conversions.
\513\ This includes 225 bank, mutual fund, and insurance record-
keepers, and an additional 1,800 third party administrators that
provide some recordkeeping for the plans they administer. The number
of participant accounts serviced by these record-keepers varies
widely, with some servicing more than ten million accounts, and
others only providing service to a few hundred or thousand accounts.
The costs we provide here are estimates for the average record-
keeper, and we acknowledge that the larger firms will likely incur
significantly higher costs, while the smaller firms may incur far
less.
\514\ These funds might include funds that have re-assessed the
asset-based distribution fees they charge and restructured their
fees to identify non-distribution services that could be paid
separately from the asset-based distribution fee limits of our
proposal, in the manner discussed in Section V.D.2.b of this
Release, supra.
\515\ The staff assumes that record-keepers would continue to
receive approximately the same amount of compensation for the
services they provide. Record-keepers currently often receive some
or all of their compensation from 12b-1 fees deducted from
participant funds. The staff expects that much of the compensation
that is currently paid to record-keepers through a 12b-1 fee in
excess of the marketing and service fee (which would be an ongoing
sales charge that would eventually end and no longer be able to pay
for recordkeeping services) may be re-assessed and paid as an
ordinary fund expense, and not be subject to the limits on asset-
based distribution fees contained within our proposal.
\516\ These estimates are based on the following calculations:
(177 record-keepers x $1,000,000 one-time costs = $177,000,000 in
one-time costs); (177 record-keepers x $1,500,000 in annual costs =
$265,500,000 in annual costs).
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As discussed previously, under our proposed rulemaking, ongoing
sales charges would qualify as transaction based compensation, and
intermediaries who receive the ongoing sales charge may need to
register as broker-dealers under section 15 of the Exchange Act unless
they can avail themselves of an exception or exemption from
registration.\517\ The proposed rulemaking could potentially lead to
some intermediaries who are currently receiving 12b-1 fees but that are
not registered as broker-dealers under section 15 of the Exchange Act
to either no longer receive asset-based distribution fees or to
register as broker-dealers. However, we understand that virtually all
advisers and other intermediaries that currently receive 12b-1 fees in
excess of 25 basis points (thus qualifying as an ongoing sales charge)
already associate themselves with registered broker-dealers, either by
registering themselves, or by becoming an independent contractor
registered representative of a registered broker-dealer. Therefore, we
do not anticipate that, if our proposal is adopted, any intermediaries
who are currently receiving 12b-1 fees would newly register as broker-
dealers, and thus incur the costs associated with registration.
---------------------------------------------------------------------------
\517\ See supra note 168.
---------------------------------------------------------------------------
We request comment on all of the estimates and assumptions made in
this section.
Is our understanding correct? Would the proposed
rulemaking in fact require any intermediaries who are currently
receiving 12b-1 fees to register as a broker-dealer? In particular, we
request comment on what types of intermediaries, if any would be
affected, and if they are affected, how many would be required to
register or no longer receive ongoing sales charges. If intermediaries
are required to register, what kind of costs would they incur? We
currently estimate that any new entities registering as broker-dealers
would incur a time burden of 2.75 hours to complete Form BD.\518\ Are
there other costs that would be implicated by broker-dealer
registration? Would other burdens be incurred and, if so, what are
those burdens? What one-time and on-going costs, if any, would be
incurred? We request comment on the estimates and assumptions we have
made in this section.
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\518\ Form BD is the application form used by entities to apply
to the Commission for registration as a broker-dealer. See Proposed
Collection; Comment Request (Apr. 20, 2010) [75 FR 22638 (Apr. 29,
2010)] (providing estimates of and seeking comments on compliance
burden of Form BD).
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G. Disclosure
The proposal would make the following changes to the disclosure
requirements:
Amend Form N-1A to replace the current line item for 12b-1
fees in the fee table and statement of operations with two new line
items (``Marketing and Service Fee'' and ``Ongoing Sales Charge'') and
revise most of the current disclosure in the prospectus and SAI related
to the discussion of 12b-1 plans (which would no longer exist) and the
dollar amounts spent under the plans for different distribution
activities;
Eliminate the periodic reporting requirement related to
12b-1 plans in Form N-SAR, the annual and semi-annual reporting form
used by mutual funds;
Amend the statement of operations for fund income and
expenses in Regulation S-X to conform to our proposal;
Amend Forms N-3, N-4, and N-6 to conform to our proposed
changes; and
Provide better proxy disclosures for shareholder votes on
asset-based distribution fees.
These proposed disclosure changes would provide a number of
benefits, including providing more descriptive disclosure of the use
and amount of asset-based distribution fees deducted by funds in
prospectuses and SAIs, providing greater transparency of these fees to
investors, removing requirements that would become outdated, and
conforming disclosure requirements to our proposal. We have discussed
these
[[Page 47122]]
benefits in detail previously in this Release in Sections III.I and
III.M above. These benefits include providing clearer disclosure of the
amount and use of asset-based distribution fees, eliminating
potentially confusing or unnecessary disclosure, and providing better
descriptions of the fees. The amendments would provide investors access
to more relevant and transparent information that could help guide
their investment making decision when considering whether to invest in
a fund that deducts asset-based distribution fees. As discussed below,
the staff estimates that there would be no additional ongoing costs as
a result of these disclosure changes, and in fact, those ongoing costs
may decrease.
1. Revised Fee Table, Prospectus, and SAI Disclosure
The proposal would require funds to eliminate the current line item
titled ``Distribution and/or Service (12b-1) Fees'' and add, as
necessary, two items for the fees permitted under the proposal--
``Marketing and Service Fee'' and ``Ongoing Sales Charge.'' Funds that
do not currently charge asset-based distribution fees would not be
affected by these proposed amendments. The staff estimates that funds
that charge asset-based distribution fees would be able to complete the
revised fee table in the same amount of time, and for the same cost
because the revised fee table only includes data that is readily
available when the fund regularly updates the fee table, and does not
include any new information. The revised fee table would not be
significantly longer, and would instead simply include a new line item,
which is a breakdown of an existing line item, that was already known
when the fee was instituted.\519\ Therefore, the staff estimates that
the proposed new line items in the fee table would not increase costs
or the amount of time required to complete Form N-1A, either initially
or when submitting a post-effective amendment.
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\519\ There are two types of Form N-1A filings; (i) Initial
filings, and (ii) annual post-effective amendments. Funds usually
incur significantly more time and incur greater costs when first
registering a fund under their initial N-1A filings than when filing
their annual post-effective updates. Therefore, the staff separately
estimates the burden for each type of filing.
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The proposal would also significantly revise the disclosure
required for funds with 12b-1 fees in the prospectus narrative and in
the SAI. These proposed amendments would eliminate many disclosures
that would become outdated or irrelevant based on our proposed rule
changes, including some of the most detailed disclosures of the dollar
amount the fund spends on each distribution activity. However, some of
the other disclosure requirements regarding asset-based distribution
fees currently in Form N-1A would be retained in the same or similar
form.\520\ Thus, we anticipate that the proposed amendments would
reduce the amount of time needed to provide disclosure on asset-based
distribution fees on an ongoing basis, although some one-time costs may
be incurred to initially revise and update the prospectus to conform
its description regarding asset-based distribution fees to the proposed
new framework.
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\520\ See Section III.J, supra.
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In our most recent Paperwork Reduction Act submission for Form N-
1A, the staff estimated that for each fund portfolio or series, the
initial filing burden is approximately 830.47 hours at a cost of
$20,300, and the post-effective amendment burden is approximately 111
hours at a cost of $8894. This includes time spent by inside counsel,
back office personnel, compliance professionals, and others in filling
out the form. The costs include that of outside counsel to prepare and
review these filings. We assume that only funds that charge asset-based
distribution fees would be affected by our proposed amendments to Form
N-1A. The staff estimates that, each year, there are approximately 7367
funds with 12b-1 plans that file post-effective amendments.
The staff estimates that our proposed amendments would result in
time savings of approximately 10 hours for each portfolio's initial
filing (for a new total estimate of 820.47 hours) and of 1 hour for
each post-effective amendment (for a new total estimate of 110 hours).
The staff further estimates that the amendments would reduce costs
spent on outside counsel, and other costs associated with completing
Form N-1A, by $500 for each initial filing (for a new total estimate of
$19,800) and $150 for each post-effective amendment (for a new total
estimate of $8744). In addition, the staff estimates that each fund
would incur a total one-time cost of $2000 and a one-time time
expenditure of 10 hours of attorney time at a rate of $316 per hour to
initially revise their post effective amendments to Form N-1A to meet
the requirements of the proposed amendments for the first time.
The staff estimates that, in each year following the effective date
of the proposed amendments, 300 additional funds with asset-based
distribution fees would file an initial Form N-1A. Based on these
estimates, the staff estimates that funds would save a total of 3000
hours (at an internal time cost equivalent of $948,000) \521\ and
$150,000 when submitting initial Form N-1A filings each year.\522\ In
addition, the staff anticipates that funds would save approximately
7367 hours (at an internal time cost equivalent of $2,327,972)\523\,
and $1,050,050 annually when preparing post-effective updates to Form
N-1A.\524\ Finally, the staff estimates that all funds with asset-based
distribution fees would incur a total one-time expenditure of 73,670
hours (at an internal time cost equivalent of $23,279,720) and a cost
of $14,734,000 when preparing post-effective amendments to comply with
the proposed amendments for the first time.\525\
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\521\ This estimate is based on the following calculation: (300
new filers x 10 hours savings = 3,000 hours in total savings);
(3,000 hours x $316 per hour = $948,000).
\522\ This estimate is based on the following calculations: (300
new filers x $500 savings = $150,000 total savings).
\523\ This estimate is based on the following calculation:
(7,367 amendments x 1 hour savings = 7,367 hours in total savings);
(7,367 hours x $316 per hour = $2,327,972).
\524\ This estimate is based on the following calculations:
(7,367 amendments x $150 savings = $1,105,050 total savings).
\525\ This estimate is based on the following calculations:
(7,367 amendments x 10 hours expended = 73,670 hours); (73,670 hours
x 316 per hour = $23,279,720); (7,367 amendments x $2,000 costs =
$14,734,000 total one-time costs).
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We request comment on these estimates and assumptions.
2. N-SAR Periodic Reporting
Our proposal would amend the instructions to Form N-SAR, which
currently requires funds to respond to a series of questions regarding
their 12b-1 plans. Form N-SAR is the form that registered investment
companies use to make periodic reports to the Commission. Our proposed
amendments would add an instruction to Form N-SAR to disregard, for
funds that no longer have 12b-1 plans, four questions (Items 41-44)
that relate to the operation of rule 12b-1 plans (because they would be
irrelevant in light of our proposed new framework for asset-based
distribution fees). However, funds that maintain grandfathered fund
classes would continue to respond to these items.
The staff estimates that there are approximately 1292 management
investment companies that respond to Items 41-44 of Form N-SAR. The
staff estimates that our proposed amendments would reduce the time it
takes funds that do not have grandfathered share classes to complete
[[Page 47123]]
Form N-SAR by 0.25 hours, and that there would be no change for funds
that maintain grandfathered share classes. The staff estimates that, if
these amendments are adopted, in the first three years after adoption,
approximately 20% of these 1292 management investment companies (or
258) would no longer maintain grandfathered share classes and would
then experience the estimated savings, while the remaining 80% (or
1034) would continue to have grandfathered share classes and respond to
these items. Because Form N-SAR is completed twice a year, the staff
estimates that each respondent would save approximately 0.5 hour
annually (at an internal time cost equivalent rate of $316 per hour).
The staff therefore estimates that our proposed amendments to Form N-
SAR would result in total incremental time savings of approximately 129
hours (with a total internal time equivalent cost savings of $40,764)
\526\ annually.
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\526\ This estimate is based on the following calculation: (258
x 0.5 hours = 129 hours); (129 hours x $316 per hour = $40,764).
---------------------------------------------------------------------------
We request comment on these estimates and assumptions.
3. Regulation S-X
As discussed in Section III.L of this Release, we are proposing
changes to rule 6-07 of Regulation S-X, which requires funds to file a
statement of operations listing income and expenses, and state
separately all amounts paid in accordance with a 12b-1 plan. Our
proposal would conform the disclosure requirement to the terms of our
proposed new rule and rule amendments regarding asset-based
distribution fees, by requiring that funds state separately amounts
charged for marketing and service fees and ongoing sales charges.
Our understanding is that funds already have information on asset-
based distribution fees available in order to prepare the statement of
operations as we have proposed. Funds analyze this information as a
matter of course for ordinary business and tax reasons, and therefore
our proposed changes to Regulation S-X would not require the
preparation of new information. Accordingly, the staff estimates that
our proposed changes to Regulation S-X would not change the amount of
time or the costs required for funds to prepare their statements of
operations under the regulation.
We request comment on these estimates and assumptions.
4. Form N-3, N-4, and N-6
The proposal would revise the currently required disclosure for
12b-1 plans in the prospectus narrative and in the SAI of Form N-3.
These proposed amendments would eliminate disclosures that would become
outdated or irrelevant based on our proposed rule changes, including
some of the most detailed disclosures of the exact dollar amount the
registrant spends on each distribution activity. However, much of the
general disclosures regarding asset-based distribution fees currently
in Form N-3 would be retained in the same or similar form.\527\
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\527\ See supra Section III.L.
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In our most recent Paperwork Reduction Act submission for Form N-3,
the staff estimated that for each portfolio, the initial filing burden
is approximately 922.7 hours at a cost of $20,300, and the post-
effective amendment burden is approximately 154.7 hours at a cost of
$7650. This hourly burden includes time spent by in-house counsel, back
office personnel, compliance professionals, and others in preparing the
form. The costs include that of outside counsel to prepare and review
these filings.
The staff assumes that only registrants that charge asset-based
distribution fees would be affected by our proposed amendments to Form
N-3. Based upon a review of filings with the Commission, the staff
estimates that 1 registrant that currently files on Form N-3 charges
asset-based distribution fees, and would file a post effective
amendment. The staff estimates that it would cost this registrant
approximately $2000 in one-time costs (for outside legal counsel
drafting and review) and require an expenditure of 10 hours in internal
personnel time (at an internal time cost equivalent rate of $316 per
hour) to revise its prospectus to comply with the proposed amendments.
The staff further estimates that the proposed amendments to Item 21 and
instruction 5 of Item 26 would result in time savings when completing a
post-effective amendment of Form N-3. The staff estimates that this
registrant would save approximately 1 hour (at an internal time cost
equivalent of $316 per hour) annually as a result of the proposed
amendments.
The staff further estimates that no new registrants that file on
Form N-3 are likely to charge asset-based distribution fees under
proposed rule 12b-2 and the proposed amendments to rule 6c-10.
Accordingly, the staff estimates that there will be no other changes in
burden hours or costs as a result of the proposed rule and rule
amendments.
We request comment on any of these estimates or
assumptions.
Our proposal would also amend Forms N-4 and N-6 to conform them to
the new rule and rule amendments that we are proposing today.\528\ The
proposed form amendments would replace references to rule 12b-1 with
references to proposed rules 6c-10(b), 12b-2(b) or 12b-12(d), as
appropriate. We expect this would benefit investors because it would
more accurately describe these fees.
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\528\ Form N-3 is used by separate accounts offering variable
annuity contracts that are registered as management investment
companies. Form N-4 is used by separate accounts offering variable
annuity contracts and are registered as unit investment trusts. Form
N-6 is used by separate accounts offering variable life insurance
contracts and are registered as unit investment trusts.
---------------------------------------------------------------------------
The staff estimates that the proposed amendments to these forms
would not change current estimates of the amount of time or costs
associated with completing the forms because they are primarily
technical and only conform the disclosure to the proposal. Therefore,
we estimate no costs will result from these proposed Form N-4 and N-6
changes.
We request comment on these estimates and assumptions.
5. Streamlined Proxy Procedure
Our proposal would eliminate a number of disclosures in Schedule
14A (the form for proxy statements) that would become irrelevant in
light of the proposed rule and rule amendments.\529\ We anticipate that
the proposed amendments would result in cost savings to funds that
prepare such proxies when obtaining shareholder consent to increase or
implement marketing and service fees.
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\529\ See proposed Item 22 of Schedule 14A.
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Funds that rely on proposed rule 12b-2(d) would not be permitted to
institute new 12b-1 plans or increase the rate of a 12b-1 fee under an
existing plan after the rule's compliance date, and therefore they
would no longer solicit proxies in relation to their 12b-1 plans.
Proposed rule 12b-2(b) would require a shareholder vote and attendant
proxy solicitation when a fund institutes or increases a marketing and
service fee in existing share classes.\530\
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\530\ As discussed in Section III.N.4 of this Release, supra, we
would not require a shareholder vote if a 12b-1 fee is relabeled a
marketing and service fee, provided the fee is 25 basis points or
less and is not increased.
---------------------------------------------------------------------------
Commission staff estimates that approximately 3 funds would solicit
proxies each year for the purposes of implementing or increasing a fee
under
[[Page 47124]]
proposed rule 12b-2(b) (the same number that we have previously
estimated would solicit proxies under rule 12b-1). Funds typically hire
outside legal counsel and proxy solicitation firms to prepare, print,
and mail these proxies. For each of these 3 funds, the staff estimates
that our proposed amendments to Schedule 14A would result in an
incremental burden reduction of 3 hours of internal personnel time (at
an internal time cost equivalent rate of $316 per hour) and reduced
costs of $400 for the services of outside professionals. The staff
therefore estimates that these amendments will reduce the total annual
costs of soliciting proxies and completing Schedule 14A by
approximately 9 hours of internal personnel time (3 funds x 3 hours) at
a internal time cost equivalent of $2,844 \531\ and approximately $1200
(3 funds x $400) for the services of outside professionals.
---------------------------------------------------------------------------
\531\ This estimate is based on the following calculation: (9
hours x $316 per hour = $2844).
---------------------------------------------------------------------------
H. Account-Level Sales Charge Alternative
Proposed rule 6c-10(c) would provide funds the option of offering a
class of fund shares that could be sold by dealers with sales charges
set at negotiated rates. The sales charge could vary in amount, or time
of payment, and could better reflect services provided by the broker.
We assume that a limited number of funds would choose to rely on this
exemption immediately, and that reliance on the exemption may increase
over time as funds and dealers better understand the costs and benefits
associated with a different business model.
1. Benefits
Some of the benefits that may derive from this exemption include
enhanced competition in fund distribution, greater transparency of
distribution charges for fund investors, and reduced conflicts for
broker-dealers selling funds with different compensation
structures.\532\ Other benefits include less complicated distribution
structures and reduced training required for registered representatives
of broker-dealers. This part of the proposal could also prompt new
innovative fund distribution systems and allow the development of new
business models. We discuss the many other potential benefits of this
proposal in detail in Sections III.I and III.M above.
---------------------------------------------------------------------------
\532\ We have not received any applications for an exemption
from section 22(d) that are similar to our proposal, so we assume
the proposal would not result in cost savings related to reduced
preparation and processing of exemptive applications.
---------------------------------------------------------------------------
2. Costs
Proposed rule 6c-10(c) is elective, and thus only funds or dealers
that choose to rely on it would incur the costs of complying with its
conditions. Proposed rule 6c-10(c) requires a fund that chooses to rely
on the exemption to meet the following two conditions: (i) The fund
must not deduct an ongoing sales charge pursuant to proposed rule 6c-
10(b); and (ii) the fund must disclose that it has elected to rely on
the exemption in its registration statement. The first condition
(prohibiting funds from deducting an ongoing sales charge) should not
impose any costs on funds. We expect that any fund that relies on
proposed rule 6c-10(c) would do so as part of the creation of a new
fund or fund class, and that therefore no funds with ongoing sales
charges would incur costs in eliminating these charges.
We estimate that funds may incur some minor costs in complying with
the second condition, the requirement to disclose the election to rely
on proposed rule 6c-10(c) in their registration statement. The staff
estimates that to make the required disclosure on the registration
statement it would require one hour of time spent by outside counsel,
charged at the rate of $400 per hour. Once the disclosure has been
initially made on the registration statement, the staff estimates that
there would be no further costs or time to update or revise the
election, and therefore there would be no annual costs. Thus, the staff
estimates that the cost of complying with the conditions in relying on
rule 6c-10(c) would be a one-time initial cost of $400 per fund. The
staff estimates that between 10 and 100 new funds might rely on
proposed 6c-10(c) for the first time each year, and therefore estimate
that the total costs for all funds to comply with the proposed
exemption would be between $4000 and $40,000 \533\ in one-time costs
(to newly formed funds) each year.
---------------------------------------------------------------------------
\533\ This estimate is based on the following calculations: (10
funds x $400 = $4000; 100 funds x $400 = $40,000).
---------------------------------------------------------------------------
We anticipate that funds that rely on proposed rule 6c-10(c) would
do so as part of a decision to provide competitive alternatives to
other distribution models, and that any other costs not imposed by the
conditions of the rule to establish the structure would be justified by
the anticipated benefits accruing to the fund. Other such costs to
establish the new distribution structure might include setting up new
classes of the fund, negotiating new distribution agreements with
broker-dealers, and educating investors and financial representatives
about the new fee structure.\534\ The decision to rely on the proposed
rule would be driven by business factors, and the potential for new
markets and customers. Funds and broker-dealers that do not choose to
rely on this exemption would not bear any costs related to the proposed
rule.\535\
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\534\ Based on discussions with one fund, that fund suggested
that these and similar efforts could include one-time costs of
$550,000 and ongoing costs of $250,000 annually per fund family.
\535\ Broker-dealers could face certain difficulties related to
``investor portability'' or account transfers for investors in
classes that rely on the proposed rule. Broker-dealers may encounter
recordkeeping or other issues when an investor account that holds
fund shares in such a class is transferred to a broker-dealer that
only sells shares of the fund with asset-based distribution fees.
Broker-dealers currently face this issue when transferring investor
accounts today (if, for example, the transferred account includes
shares of a fund that the new broker-dealer does not sell), although
it may be exacerbated by the different fee structure the exemption
offers.
---------------------------------------------------------------------------
We request comment on the discussion of the costs and benefits of
our proposed rule 6c-10(c).
Are there any costs that this exemption would impose on
funds or others? What other benefits might it provide? What should we
assume about the compensation structure that brokers would design? How
many funds are likely to take advantage of this exemption, and what
kind of factors would drive this choice? What kind of costs would these
funds incur? Are our estimates of the cost of complying with the
conditions of the exemptions reasonable?
As discussed previously, our experience with unfixing commission
rates leads us to expect that when sales loads are subject to market
pressure, sales loads will go down for all investors. However, we
acknowledge the potential that some investors (perhaps due to a lack of
bargaining power) may pay higher sales loads under proposed rule 6c-
10(c) than they might have under the fixed sales load regime of section
22(d). We request comment as to whether investors are likely to pay
lower (or higher) sales loads if they purchase fund shares from a fund
taking advantage of the proposed exemption.
Are investors likely to experience any other costs or
benefits as a consequence of the proposed exemption? If the exemption
is widely relied upon, what might be the effect on distribution
arrangements, and on distributors that do not rely on the rule?
[[Page 47125]]
I. Director Responsibilities
Board of directors' responsibilities would change under the
proposal because we would not require directors to adopt and annually
renew a 12b-1 plan or make any special findings.\536\ The proposal
would not impose other procedural requirements currently in rule 12b-1,
including the requirements for quarterly review. Although the proposal
would eliminate director specific oversight requirements, directors
would still have a fiduciary obligation to consider whether the asset-
based distribution fees are in the best interest of the fund and fund
shareholders.
---------------------------------------------------------------------------
\536\ Our proposed rescission of rule 12b-1 would also eliminate
the recordkeeping requirements in rule 12b-1(f) to maintain copies
of the plan, reports or any other agreements related to the plan.
Although our proposal would not impose recordkeeping requirements,
we do not anticipate that funds would realize any cost savings as a
result of this amendment, because they would continue to maintain
records regarding their asset-based distribution fees to prepare
their financial statements.
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1. Benefits
We expect that the proposed reduction in formal requirements
regarding the approval of asset-based distribution fees would result in
significant cost and time savings for funds and their investors. The
staff has estimated in our most recent Paperwork Reduction Act analysis
for rule 12b-1 that, for each fund family that has at least one fund
with a 12b-1 plan, it takes approximately 425 hours for the fund's
directors, counsel, accountants, and other staff to maintain the plan,
prepare and evaluate quarterly reports, make the necessary findings,
and hold director votes, at an internal time cost of $99,811 per fund
family. The staff estimates that there are approximately 379 fund
families with at least one fund that charges 12b-1 fees. Therefore, the
staff estimates that for all fund families with a 12b-1 plan, funds
expend a total of 161,075 hours at an internal time cost of
$37,828,369.\537\
---------------------------------------------------------------------------
\537\ These estimates are based on the following calculations:
(425 hours x 379 fund families = 161,075 hours; $99,811 x 379 fund
families = $37,828,369).
---------------------------------------------------------------------------
The staff estimates that our proposal would reduce this burden by
approximately 75% (proportionately for all fund employees) for an
annual hour reduction for each fund family of 319 hours, and a $74,858
reduction in internal costs.\538\ If our proposal is adopted, we
estimate that funds, their employees (or the employees of the adviser),
and directors would only need to spend 106 hours instead of 425 hours
annually on asset-based distribution fee matters pursuant to rules 12b-
2 and 6c-10, at an internal cost of $24,953 instead of $99,811.\539\
Therefore, the staff estimates that our proposed amendments to director
responsibilities and the proposed removal of rule 12b-1 would reduce
this total time from a total of 161,075 hours per year at an internal
cost of $37,828,369, to 40,269 hours at an annual cost of $9,457,092
\540\ resulting in an annual savings of 120,806 hours and $28,371,277
dollars.\541\
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\538\ This estimate applies to both funds that deduct asset-
based distribution fees under proposed rules 12b-2(b) and 6c-10, and
to funds that deduct grandfathered 12b-1 fees pursuant to proposed
rule 12b-2(d).
\539\ These estimates are based on the following calculations:
(425 hours x 25% = 106 hours; $99,811 x 25% = $24,953).
\540\ These estimates are based on the following calculations:
(161,075 hours x 25% = 40,269 hours; $37,828,369 x 25% =
$9,457,092).
\541\ These estimates are based on the following calculations:
(161,075 hours x 75% = 120,806 hours; $37,828,369 x 25% =
$28,371,277).
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We request comment on these estimates and assumptions.
2. Costs
Other than the time expenditures we have outlined previously in
this analysis, we do not expect that there will be any costs associated
with our proposed removal of rule 12b-1 and clarification of director
responsibilities in our proposal. As discussed above, we anticipate
that the proposed changes would simplify the requirements for imposing
asset-based distribution fees compared to the current requirements of
rule 12b-1. Costs that a fund might incur in connection with revising
disclosures regarding asset-based distribution fees are discussed
above.\542\
---------------------------------------------------------------------------
\542\ See supra Section V.G of this Release.
---------------------------------------------------------------------------
We request comment on these estimates and assumptions.
J. 11a-3 Amendments
We are also proposing to amend rule 11a-3 (which governs sales
loads on offers of exchange within a fund family) to bring it into
conformity with the proposed treatment of ongoing sales charges we
describe in this Release. The proposed amendments would require funds
to give shareholders ``credit'' against the rate of any sales load owed
for ongoing sales charges paid by investors who exchange fund shares
within a fund group.\543\
---------------------------------------------------------------------------
\543\ A more detailed description of these amendments is
included in Section III.K of this Release, supra.
---------------------------------------------------------------------------
1. Benefits
We anticipate that the proposed amendments to rule 11a-3 would
provide a number of benefits. Some of the principal benefits include
more equitable treatment of investors who pay sales charges, whether
with the initial investment, or over time, and greater transparency in
sales charges paid.
2. Costs
Based on conversations with industry representatives, the staff
understands that most funds that currently rely on the exemptive relief
provided by rule 11a-3 have systems that can credit ongoing sales
charges in the way the proposed amendments would require. In order to
process credits for CDSLs (and other purposes), funds (or their
transfer agents) use a bucketing system that allows them to track the
history of fund shares. The staff understands that these existing
systems can track the length of time shares subject to an ongoing sales
charges have been held, determine the charges that have been paid, and
credit those charges against any load imposed on the new shares
acquired in an exchange. The staff understands that most funds
generally limit exchanges to shares of the same class in other funds
within the fund group. As a result, when transferred, the ongoing sales
charge and conversion date of both the exchanged and acquired shares
would generally be the same, if the maximum sales load remains the
same. In those circumstances, no action would be required on the part
of the fund or its transfer agent. Alternatively, the conversion date
may need to be changed (if, for example, the maximum sales loads of the
two funds are different). We expect that most funds should be able to
comply with our proposed 11a-3 amendments with little difficulty.
Funds may still need to update their systems for share exchanges
and enhance their capacity to include shares with ongoing sales
charges. The staff therefore estimates that a typical fund family with
funds that deduct ongoing sales charges (or the fund's transfer agent)
would incur $25,000 in one-time costs to update its systems to comply
with our proposed amendments. For purposes of this analysis, the staff
assumes that all 196 fund families that may be affected by our ongoing
sales charge proposal would incur this cost, for a total cost of
$4,900,000.\544\
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\544\ This estimate is based on the following calculation: (196
fund families x $25,000 = $4,900,000).
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We request comment on these estimates and assumptions.
[[Page 47126]]
K. Other Technical Amendments
Our proposal would make a number of technical amendments to
Investment Company Act rules and forms, removing current references to
rule 12b-1 and adding references to the appropriate proposed rule.\545\
We do not expect these changes to materially affect funds,
intermediaries, or others, because they are technical changes that
should not affect fund operations. Therefore, we do not believe that
there would be any costs associated with these amendments. We request
comment on this assumption.
---------------------------------------------------------------------------
\545\ These proposed technical amendments would affect rules
17a-8, 17d-3, 18f-3, and Regulation S-X under the Act. For a
complete discussion of the changes, see Section III.L of this
Release, supra.
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Would there be any costs associated with making the
technical changes described in Section III.L above?
L. Rule 10b-10
The proposed amendments to Exchange Act rule 10b-10 would provide
broker-dealer customers with additional information related to mutual
fund costs and callable securities.
1. Benefits
The improved disclosure related to mutual fund costs could be
expected to help make the confirmation a more complete record of the
transaction and help mutual fund investors more fully understand the
sales charges they incur. Those improved disclosures could be expected
to promote decision making by investors that more appropriately takes
those costs into account. Those improved disclosures also could be
expected to assist investors in verifying whether they paid the correct
sales charge set forth in the prospectus. The improved disclosure
related to callable debt securities could be expected to help alert
investors to misunderstandings, avoid confusion, promote the timely
resolution of problems, and better enable investors to evaluate
potential future transactions.
2. Costs
These proposed amendments to rule 10b-10 would require brokers-
dealers to include additional information in confirmations that are
currently sent to investors. The costs of adding this new information
into confirmation disclosures would largely be expected to be one-time
programming-related costs, borne primarily by clearing firms and third-
party service providers, which are included in the estimates of the
Paperwork Reduction Act burden. For purposes of the Paperwork Reduction
Act, the Commission staff has estimated that the one-time burden to
clearing firms with proprietary systems to reprogram software and
otherwise update their systems to enable them to generate confirmations
meeting the requirements of the proposed amendments would be
approximately 720,000 hours.\546\ The staff estimates that this one-
time burden would equal total internal costs of approximately $180.7
million dollars,\547\ or $1.1 million per vendor.\548\ The staff also
estimates that vendor licensors of platforms would incur costs
equivalent to those incurred by clearing firms with proprietary
systems, resulting in one-time burden of 13,500 hours and costs of
approximately $3.4 million dollars,\549\ or $1.1 million per
vendor.\550\ In addition, the staff understands that clearing firm
licensees would incur an additional 800 burden hours each, or 296,000
total, for a total cost of approximately $74.3 million,\551\ or
$200,800 per clearing firm licensee.\552\
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\546\ 4,500 burden hours x 160 clearing firms with proprietary
systems = 720,000 burden hours. See note 437 supra and accompanying
text.
\547\ 720,000 hours x $251 dollars per hour = $180,720,000.
These figures are based on an estimated hourly wage rate of $251.
The estimated wage figure is based on published compensation for
compliance attorneys ($291) and the average costs of a senior
computer programmer ($285) and a computer programmer analyst ($190)
(($190 + $285) / 2 = $238). See Securities Industry and Financial
Markets Association, Management and Professional Earnings in the
Securities Industry (Sept. 2009). The staff estimates that
programmers would utilize 75% of the burden hours to implement
system changes while attorneys would utilize 25% of the burden hours
to review the output, yielding a weighted wage rate of $251 dollars
per hour (($291 x .25) + ($238 x .75)) = $251).
\548\ 4,500 burden hours x $251 dollars per hour = $1,129,500.
\549\ 3 vendors x 4,500 burden hours x $251 dollars per hour =
$3,388,500. For purposes of this analysis, the staff assumes that
vendors would incur the same per hour costs and burden hours
incurred by clearing firms with proprietary systems. See note 438
supra.
\550\ 4500 burden hours per vendor x $251 dollars per hour =
$1,129,500.
\551\ 370 clearing firm licensees x 800 burden hours x $251
dollars per hour = $74,296,000. For purposes of this analysis, the
staff also assumes that vendors or other third-parties would perform
the work needed to adapt each of these clearing firms' systems to
the changes made to its vendor's platform. The staff further assumes
the hourly costs to clearing firms to outsource these additional
burdens to third-parties would be equivalent to the hourly costs
incurred by vendors and by clearing firms with proprietary systems.
This hourly cost is estimated at approximately $251 per hour. See
note 438 supra.
\552\ 800 burden hours per clearing firm licensee x $251 per
hour = $200,800.
---------------------------------------------------------------------------
When we include the costs borne by vendors and clearing firm
licensees, we estimate that total one-time burden as a whole would be
approximately $258.4 million dollars.\553\
---------------------------------------------------------------------------
\553\ ((3 vendors x 4,500 burden hours) + (370 clearing firm
licensees x 800 burden hours) + (160 clearing firms with proprietary
systems x 4,500 burden hours)) x $251 per hour = $258,404,500. As
discussed above, the staff believes that all parties would incur
costs of $251 per hour.
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We request comment on these estimates and assumptions.
M. Total Costs and Benefits
As discussed above, we have designed our proposal to minimize the
cost impact on funds, intermediaries, and service providers while
maximizing the investor protection and other benefits. The staff
anticipates that funds representing approximately 93% of all assets
under management will incur minor or no expenses in complying with our
proposal.\554\
---------------------------------------------------------------------------
\554\ See supra Section V.B of this Release.
---------------------------------------------------------------------------
The staff estimates that the total one-time costs of compliance
with our proposed amendments would be $400,994,000 in outside expenses
and $362,348,000 in internal time cost equivalents. The staff further
estimates the total annual costs of compliance would be $304,076,000.
The staff also estimates that the total annual benefits of compliance
with our proposed amendments would be between $1,062,361,000 to
$1,258,361,000 in cost savings and $31,963,000 in internal time cost
equivalents. This does not reflect our full expectation of the costs
and benefits of the proposed amendments because many of the expected
costs and benefits are qualitative in nature.
We request comment on these estimates.
N. Request for Comment
We request comments on all aspects of this cost-benefit analysis,
including identification of any additional costs or benefits of, or
suggested alternatives to, the proposed amendments. Commenters are
requested to provide empirical data and other factual support for their
views to the extent possible. In particular, we request comment on the
quantitative estimates made within this section and any other costs or
benefits that were not discussed here that might result from the
amendments. We encourage commenters to identify, discuss, analyze, and
supply relevant data regarding any additional costs and benefits.
VI. Initial Regulatory Flexibility Analysis
This Initial Regulatory Flexibility Analysis (``IRFA'') has been
prepared in accordance with 5 U.S.C. 603. It relates to the
Commission's proposed removal
[[Page 47127]]
of rule 12b-1, new rule 12b-2, and amendments to rules 6c-10, 10b-10,
11a-3, 17a-8, 17d-3, and 18f-3, and amendments to Forms N-1A, N-3, N-4,
N-6, N-SAR and Regulation S-X and Schedule 14A, under the Securities
Act, the Securities Exchange Act, and the Investment Company Act.
A. Reasons for, and Objectives of, the Proposed Actions
As more fully described in Sections I, II, and III of this Release,
we are proposing a new rule and rule and form amendments designed to
address funds' use of asset-based distribution fees, to amend our
current regulations to reflect current economic realities and the role
of directors regarding these charges, and to enhance transparency and
equity of these fees for investors. Rule 12b-1, the current rule that
governs the use of asset-based distribution fees, relies on fund
directors to oversee the level and use of these fees. Asset-based
distribution fees have evolved into a substitute for front-end loads,
and have also enabled the development of new models of fund
distribution that could not have been anticipated when the rule was
adopted. Small funds, in particular, often rely on asset-based
distribution fees as a means of gaining access to distribution channels
that would not otherwise be available to them.\555\
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\555\ See, e.g., Roundtable Transcript, supra note 109, at 67-68
(statement of Mellody Hobson, Ariel Capital Management, LLC), and
discussion of the impact of the proposal on small funds, Section
III.M, supra.
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The proposal is also designed to improve investor understanding of
these fees and their purposes, as well as to enhance equity in the
amount of distribution costs all fund shareholders pay, regardless of
the method of payment. Currently, investors may not understand that
asset-based distribution fees are the equivalent of sales loads, and
some investors may believe that they have avoided a sales load entirely
by purchasing a share class that charges an asset-based distribution
fee. In addition, under current distribution practices, certain long-
term shareholders that pay asset-based distribution fees may subsidize
the distribution expenses of other shareholders in the fund. As a
result, some fund shareholders may pay a disproportionate amount of the
fund's distribution expenses.
Our proposed new rule, and rule and form amendments, would
significantly revise our current regulations regarding asset-based
distribution fees by eliminating the specific requirements for the
board of directors. The proposal would recognize that funds bear
ongoing expenses that, although they are distribution related, may
benefit the fund and fund shareholders, and would replace the specific
formal requirements for the board with other regulatory protections. In
particular, the proposal would recognize that asset-based distribution
fees may be used as a substitute for a sales load, and would regulate
them in a similar manner. We expect that this would give directors more
time to focus on other important fund matters. In order to provide
greater equity among shareholders who bear distribution fees, the
proposal would limit the amount of asset-based distribution fees that
may be charged to each investor. Funds would be required to convert
shares that have an ongoing sales charge to a class that does not
impose an ongoing sales charge no later than when the cumulative
charges equal the amount of the highest front-end load that the
investor would have paid had the investor invested in another class of
shares in the same fund, or after a set conversion period based on the
rate of the front-end load and the rate of the ongoing sales charge
imposed.
In addition, the proposal would allow funds that deduct a marketing
and service fee pursuant to rule 12b-2 to sell their shares at other
than the public offering price as disclosed in their prospectus. This
would enable funds to offer new choices to investors in paying for the
costs of distribution; enhance competition in pricing between broker-
dealers in the sale of fund shares; and present new business
opportunities to funds that choose to use this exemption. We believe
small funds may be the funds that are more likely to so experiment and
use this exemption to expand their market opportunities.
Finally, the proposal would also make a number of changes to
current disclosure requirements designed to enhance investor
understanding of these fees. In particular, the proposal would require
the prospectus fee table to state separately (i) the amount of asset-
based distribution fees that pays for services received by shareholders
in the fund and for other general distribution purposes (the marketing
and service fee), and (ii) the amount of asset-based distribution fees
that are a substitute for a sales load (the ongoing sales charge). This
disclosure is designed to allow fund shareholders to understand better
the purpose of these fees, and the amounts they are paying. The
proposal would also make a number of conforming changes to other rules
and forms that are intended to update current references to rule 12b-1
to reflect the regulations we are proposing today, as well as
eliminating or updating requirements that would become irrelevant if
our proposal were adopted. The proposal further would make changes to
rule 10b-10 to improve disclosure on broker-dealer confirmations of
costs related to mutual funds and to make other improvements.
B. Legal Basis
The Commission is proposing amendments to Schedule 14A under the
authority set forth in sections 3(b), 10, 13, 14, 15, 23(a), and 36 of
the Exchange Act [15 U.S.C. 78c(b), 78j, 78m, 78n, 78o, 78w(a), and
78mm], and sections 20(a), 30(a), and 38(a) of the Investment Company
Act [15 U.S.C. 80a-20(a), 80a-29(a), and 80a-37(a)]. The Commission is
proposing amendments to rule 6-07 of Regulation S-X under the authority
set forth in section 7 of the Securities Act [15 U.S.C. 77g] and
sections 8 and 38(a) of the Investment Company Act [15 U.S.C. 80a-8,
80a-37(a)].
The Commission is proposing to remove rule 12b-1 under the
authority set forth in sections 12(b) and 38(a) of the Investment
Company Act [15 U.S.C. 80a-12(b) and 80a-37(a)]. The Commission is
proposing new rule 12b-2 under the authority set forth in sections
12(b) and 38(a) of the Investment Company Act [15 U.S.C. 80a-12(b) and
80a-37(a)]. The Commission is proposing amendments to rule 6c-10 under
the authority set forth in sections 6(c), 12(b), 22(d)(iii), and 38(a)
of the Investment Company Act [15 U.S.C. 80a-6(c), 80a-12(b), 80a-
22(d)(iii) and 80a-37(a)]. The Commission is proposing amendments to
rules 11a-3, 17a-8, 17d-3, and 18f-3 under the authority set forth in
sections 6(c), 11(a), 17(d), 18(i), and 38(a) of the Investment Company
Act [15 U.S.C. 80a-6(c), 80a-11(a), 80a-17(d), 80a-18(i) and 80a-
37(a)].
The Commission is proposing amendments to Form N-SAR under the
authority set forth in sections 10(b), 13, 15(d), 23(a), and 36 of the
Securities Exchange Act [15 U.S.C. 78j(b), 78m, 78o(d), 78w(a), and
78mm], and sections 8, 13(c), 24(a), 30, and 38 of the Investment
Company Act [15 U.S.C. 80a-8, 80a-13(c), 80a-24(a), 80a-29, and 80a-
37]. The Commission is proposing amendments to registration Forms N-1A,
N-3, N-4, and N-6, under the authority set forth in sections 6, 7(a),
10, and 19(a) of the Securities Act [15 U.S.C. 77f, 77g(a), 77j,
77s(a)], and sections 8(b), 24(a), and 30 of the Investment Company Act
[15 U.S.C. 80a-8(b), 80a-24(a), and 80a-29]. The Commission is
proposing amendments to Exchange Act rule 10b-10 pursuant to the
authority conferred by the Exchange Act, including sections 10, 17,
[[Page 47128]]
23(a), and 36(a)(1) [15 U.S.C. 78j, 78q, 78w(a), and 78mm(a)(1)].
C. Small Entities Subject to the Rule
For purposes of the Regulatory Flexibility Act, an investment
company is a small entity if it, together with other investment
companies in the same group of related investment companies, has net
assets of $50 million or less as of the end of its most recent fiscal
year. Based on a review of filings submitted to the Commission,
approximately 108 investment companies registered on Form N-1A meet
this definition. These funds have approximately 189 classes. Commission
staff estimates that 40 of these investment companies have at least one
class that charges 12b-1 fees, with approximately 78 classes that
deduct 12b-1 fees. Of those 78 classes, 23 charge 12b-1 fees in excess
of 25 basis points, while the remaining 55 classes charge 12b-1 fees of
less than 25 basis points.
For purposes of the Regulatory Flexibility Act, a broker-dealer is
a small business if it had total capital (net worth plus subordinated
liabilities) of less than $500,000 on the date in the prior fiscal year
as of which its audited financial statements were prepared pursuant to
rule 17a-5(d) of the Exchange Act or, if not required to file such
statements, a broker-dealer that had total capital (net worth plus
subordinated liabilities) of less than $500,000 on the last business
day of the preceding fiscal year (or in the time that it has been in
business, if shorter) and if it is not an affiliate of an entity that
is not a small business.\556\ The Commission staff estimates that
approximately 862 broker-dealers meet this definition.\557\ Of these,
however, only 17 clearing firms can be classified as small entities
that would likely incur the costs of adopting the proposed amendments
to rule 10b-10.\558\
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\556\ 17 CFR 240.0-10.
\557\ This estimate is based on information provided in FOCUS
Reports filed with the Commission in 2009.
\558\ As discussed above, although there are approximately 5035
broker-dealers registered with the Commission to whom the rule would
apply, the staff believes that the costs of implementing the
proposed changes to rule 10b-10 would be primarily borne by clearing
firms. Also as discussed above, the staff estimates that there are
approximately 530 clearing firms. Based on FOCUS Reports filed with
the Commission in 2009, the staff believes that of these 530
clearing firms, approximately 17 come within the definition of a
small entity.
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D. Reporting, Recordkeeping, and Other Compliance Requirements
Our proposal would amend the reporting, recordkeeping, and other
compliance requirements for all funds (including small entities) that
comply with rule 12b-1, or would comply with proposed rule 12b-2,
proposed amendments to rules 6c-10, 11a-3, 17a-8, 17d-3, and 18f-3, or
that would respond to amended Forms N-1A, N-3, N-4, N-6, N-SAR,
Schedule 14A and Regulation S-X.\559\ We have estimated the costs of
these amendments for all marketplace participants previously in the
cost-benefit analysis in Section V. above. No new classes of skills
would be required to comply with our proposed new rule, or rule and
form amendments.
---------------------------------------------------------------------------
\559\ For a complete discussion of the specifics of the new rule
and rule and form amendments, see Section III, supra.
---------------------------------------------------------------------------
1. Rule 6c-10
The proposed amendments to rule 6c-10(b) would allow a fund to
deduct asset-based distribution fees from fund assets in excess of
asset-based fees permitted under proposed rule 12b-2 (an ``ongoing
sales charge''), provided shares sold subject to such an ongoing sales
charge convert to another class of shares without an ongoing sales
charge when the shareholder has paid cumulative charges or rates of
fees that are equivalent to what he or she would have paid for shares
subject to a front-end sales load. Rule 6c-10(c) would allow funds to
sell shares at a price other than described in the prospectus. This
provision is an exemption, and thus would not create any new
recordkeeping, reporting, or compliance requirements for small entities
unless they chose to rely on the exemption.
The proposed amendments would not impose any new reporting
obligations on small entities. However, small entities that charge an
ongoing sales charge would be required to keep certain new records
regarding the length of time that a shareholder holds shares and would
be required to comply with the new requirement for conversion of those
shares. Commission staff has estimated the costs of these requirements
for all funds (including small entities) in the cost-benefit analysis
in Section V above. We do not anticipate that small funds would face
unique or special burdens when complying with the proposed amendments
to rule 6c-10.
2. Removal of Rule 12b-1
We are proposing to remove rule 12b-1. As discussed above,
Commission staff has estimated that the proposed removal would reduce
costs significantly for affected funds, including the 40 small funds
that the Commission staff estimates have at least one class that
currently charges 12b-1 fees. The proposal would eliminate existing
recordkeeping, reporting, and compliance requirements, and would not
create any new ones.
3. Rule 12b-2
The proposal would include new rule 12b-2, which would permit funds
to deduct a ``marketing and service fee'' from fund assets, limited to
the amount established in the NASD sales charge rule for ``service
fees.'' Any assets a fund deducts in excess of the marketing and
service fee would be regulated under rule 6c-10 as an ongoing sales
charge. The proposal would also permit funds to continue to charge 12b-
1 fees on shares sold prior to the compliance date of the rule and rule
amendments, if they are adopted, and would continue to regulate the use
of fund assets to pay for brokerage as under rule 12b-1(h) (by
including a similar provision in proposed rule 12b-2). We have
previously estimated that almost all funds (including small funds) that
currently charge 25 basis points or less in asset-based distribution
fees under rule 12b-1 would incur no additional reporting,
recordkeeping, or compliance requirements under proposed rule 12b-2.
4. Rule 11a-3
As previously discussed, our proposal would amend rule 11a-3 to
ensure that funds give credit for ongoing sales charges when an
investor exchanges fund shares within a fund family. The proposed
amendments would expand current recordkeeping responsibilities for
funds that charge an ongoing sales charge, including small funds.
Commission staff has estimated the costs of these changes for all funds
in the cost-benefit analysis in Section V above. The staff estimates
that 40 funds qualify as small entities for purposes of the Regulatory
Flexibility Act, and that they would incur the same costs of compliance
($25,000, as estimated in section V.K above) to comply with the
proposed amendments to rule 11a-3 as larger funds, because these funds
use similar computer systems and/or transfer agents to track share
exchanges. Although the volume of rule 11a-3 share exchanges may be
less for small funds, with comparably lower costs of expanding the
systems to handle exchanges as compared to larger funds, the staff
estimates that any expenses incurred in upgrading these systems to meet
the compliance requirements of our proposal would be comparable, due to
a lack of bargaining power and economies of scale for the smaller
funds. Therefore, the Commission staff estimates that each small fund
family
[[Page 47129]]
that charges 12b-1 fees high enough to qualify as ongoing sales
charges, would incur $25,000 in expenses related to the proposed
amendments to the reporting, recordkeeping, and compliance requirements
of rule 11a-3.
5. Rules 17a-8, 17d-3, and 18f-3
Our proposal would make technical conforming changes to these rules
as discussed in Section III.L above. Commission staff estimates that
the proposed changes would create no change in the reporting,
recordkeeping, or compliance requirements for funds (including small
funds).
6. Form N-1A
Form N-1A is the form that open-end mutual funds use to register
with the Commission. The proposed amendments would require funds that
file Form N-1A to: (i) Eliminate the line item currently titled
``Distribution and/or service (12b-1) fee'' and include two line items,
(if relevant) titled ``Marketing and Service Fee'' and ``Ongoing Sales
Charge''; (ii) revise and streamline prospectus narrative disclosure on
asset-based distribution fees; and (iii) revise and streamline SAI
disclosure regarding asset-based distribution fees. The staff estimates
that the proposed changes would reduce costs for all funds, including
small entities, by reducing the amount of time and costs funds incur in
preparing the forms, and would not impose new reporting or
recordkeeping requirements.
7. Form N-3, Form N-4, and Form N-6
The proposed amendments to Forms N-3, N-4, and N-6 would conform
disclosures in these forms to our proposals.\560\ The proposed
amendments would replace references to rule 12b-1 with references to
proposed rules 6c-10(b) or 12b-2(b) and (d). Form N-3 is the
registration form used by insurance company separate accounts
registered as management investment companies that offer variable
annuity contracts. The proposed amendments to Form N-3 would: (i)
Revise and streamline prospectus narrative disclosure on asset-based
distribution fees; and (ii) revise and streamline Statement of
Additional Information disclosure regarding asset-based distribution
fees. The proposed changes would not impose new reporting or
recordkeeping requirements for Form N-3.
---------------------------------------------------------------------------
\560\ Form N-3 is used by separate accounts offering variable
annuity contracts and registered as management investment companies.
Form N-4 is used by separate accounts offering variable annuity
contracts and registered as unit investment trusts. Form N-6 is used
by separate accounts offering variable life insurance contracts and
registered as unit investment trusts.
---------------------------------------------------------------------------
The proposed changes to Forms N-4 and N-6 are technical and
designed to update references to 12b-1 plans to the new terminology
used in our proposal. These proposed changes would not change the
reporting or recordkeeping requirements of these forms. In the cost-
benefit analysis above, we explained that we do not anticipate that
these amendments would result in new costs or burdens associated with
preparing the forms. We do not believe that these amendments will
impose any new recordkeeping, reporting, or compliance requirements.
8. Form N-SAR
Our proposal would amend the instructions to Form N-SAR, which
currently requires funds to respond to a series of questions regarding
their 12b-1 plans. Form N-SAR is the form that registered investment
companies use to make periodic reports to the Commission. Our proposed
amendments would add an instruction to Form N-SAR to disregard, for
funds that no longer have 12b-1 plans, four questions (Items 41-44)
that relate to the operation of rule 12b-1 plans (because they would be
irrelevant in light of our proposed new framework for asset-based
distribution fees). However, funds that maintain grandfathered fund
classes would continue to respond to these items. The proposal would
impose no new recordkeeping, reporting, or compliance requirements, and
would instead reduce these burdens for respondents that do not have
grandfathered 12b-1 plans.
9. Schedule 14A
Funds comply with the requirements of Schedule 14A when they
solicit proxies from their shareholders. Our proposal would amend the
required disclosures under section 14A when a fund institutes or
materially increases a marketing and service fee after shares have been
offered to the public. The proposed amendments would streamline proxy
disclosures, removing items that would be superfluous if our proposed
new rules and rule amendments on marketing and service fees were
adopted. As discussed above, we have previously estimated that our
changes to Schedule 14A would not create any new reporting,
recordkeeping, or compliance burdens for funds that solicit proxies,
and would instead reduce the existing burden.
10. Regulation S-X
Regulation S-X requires funds to file a statement of operations
listing their income and expenses, and to state separately all amounts
paid in accordance with a plan adopted under rule 12b-1. Our proposal
would conform this requirement to the terms of our proposed new rules
and rule amendments regarding asset-based distribution fees. The
proposed amendments to regulation S-X would require that funds state
asset-based distribution fees paid, and state separately amounts paid
pursuant to our proposed rules on marketing and service fees and
ongoing sales charges. Our understanding is that funds, as a matter of
good business practice, already keep the information on asset-based
distribution fees in the proper form, because that information is used
to prepare information on 12b-1 fees, and is a component of the overall
statement of expenses. The staff estimates that our proposed changes to
regulation S-X would not change the amount of time or the costs
required for funds (including small funds) to prepare their statements
of operations. Therefore, we do not expect that these amendments will
impose any new recordkeeping, reporting, or compliance requirements.
11. Rule 10b-10
Exchange Act rule 10b-10 requires broker-dealers to provide
transaction confirmations to customers. The proposed amendments to this
rule would require disclosure of additional information related to
sales charges in connection with transactions involving mutual funds,
and certain additional information in connection with callable debt
securities. The proposed amendments would expand current recordkeeping
responsibilities for broker-dealers, including small broker-dealers. As
discussed above, the Commission staff estimates that the one-time
burden for clearing firms with proprietary systems associated with
these proposed amendments would equal total internal costs of
approximately $180.7 million dollars \561\ or approximately $1.1
million per clearing firm with a proprietary system.\562\ Also as
discussed above, as a general matter, medium-sized and smaller clearing
firms, and also some larger ones, use platforms licensed from vendors
to generate the data necessary to send confirmations. As discussed
[[Page 47130]]
above, the staff understands that there are three primary vendors that
license the majority of platforms to clearing firms that do not have
proprietary systems. In addition, clearing firms may also use vendors
to send physical confirmations to investors. Therefore, these vendors
would have to reprogram their software and update these platforms to
generate the data that would allow their clients to comply with these
proposed amendments to rule 10b-10. Based on discussions with industry
representatives, the staff is of the view that the cost and burdens to
vendors to update the platforms that they license to clearing firms
would be equivalent to the costs and burdens that would be incurred by
clearing firms who would have to reprogram and update their proprietary
systems, resulting in a cost to these vendors of approximately $3.4
million dollars \563\ or $1.1 million per vendor.\564\ In addition, the
staff understands that clearing firm licensees of these platforms would
still incur a one-time cost of approximately $74.3 million dollars
\565\ or $200,800 \566\ per clearing firm licensee, to adopt the
changes made to vendor platforms and to determine whether the output
satisfies the requirements of the proposed amendments.
---------------------------------------------------------------------------
\561\ (4,500 burden hours x 160 clearing firms with proprietary
systems) x $251 dollars per hour = $180,720,000.
\562\ 4,500 hours x $251 dollars per hour = $1,129,500. See note
548 supra.
\563\ (3 vendors x 4500 burden hours) x $251 dollars per hour =
$3,388,500. See note 549 supra.
\564\ 4500 hours x $251 dollars per hour = $1,129,500. See note
550 supra.
\565\ (800 burden hours x 370 clearing firms that use vendor
licensed platforms) x $251 per hour = $74,296,000. See note 551
supra.
\566\ 800 hours x $251 dollars per hour = $200,800. See note 552
supra.
---------------------------------------------------------------------------
As discussed above, of the approximately 530 clearing firms that
would incur upgrade costs, 17 of those are small entities. The staff
believes that these small entity clearing firms would likely license
their platforms from vendors. Accordingly, the staff estimates that
these firms would incur costs of approximately $200,800 each to adapt
to the changes in vendor platforms, or approximately $3.4 million
total.\567\ These figures are already included in the total burden
costs that clearing firms, and in particular, clearing firm licensees,
would incur to implement the proposed amendments to rule 10b-10.
---------------------------------------------------------------------------
\567\ (800 burden hours x 17 small entity clearing firms) x $251
per hour = $3,413,600.
---------------------------------------------------------------------------
In addition, as discussed above,\568\ the staff believes that
clearing firms will bear most of the costs associated with updating
back-office operations to accommodate the proposed changes to rule 10b-
10. Accordingly, the staff does not believe that small introducing
firms will incur these costs.
---------------------------------------------------------------------------
\568\ See Section IV.H supra.
---------------------------------------------------------------------------
12. Request for Comment
The Commission solicits comment on these estimates and the
anticipated effect the proposed amendments would have on small entities
subject to the proposed rule and rule and form amendments.
E. Duplicative, Overlapping, or Conflicting Federal Rules
We have not identified any federal rules that duplicate, overlap,
or conflict with the proposed rule or rule or form amendments.
F. Significant Alternatives
The Regulatory Flexibility Act directs us to consider significant
alternatives that would accomplish our stated objective, while
minimizing any significant adverse impact on small issuers. In
connection with the proposed amendments, the Commission considered the
following alternatives: (i) The establishment of differing compliance
or reporting requirements or timetables that take into account the
resources available to small entities; (ii) the clarification,
consolidation, or simplification of compliance and reporting
requirements under the proposed amendments for small entities; (iii)
the use of performance rather than design standards; and (iv) an
exemption from coverage of the proposed amendments, or any part
thereof, for small entities.
Investors in small funds face the same issues as investors in
larger funds when paying asset-based distribution fees. Small funds use
asset-based distribution fees as a means of growing their funds and
accessing alternate distribution channels, and our rule proposal is
designed to allow funds to continue to use asset-based distribution
fees for these purposes. We have endeavored through the proposed
amendments to minimize the regulatory burden on all funds, including
small entities, while meeting our regulatory objectives. We have tried
to design our proposal so that small entities would not be
disadvantaged, and we anticipate that the potential impact of the
proposed rule and amendments on small entities would not be
significant. Small entities should experience the same benefits from
the proposal as other funds. We have endeavored to clarify,
consolidate, and simplify disclosure for all funds, which should be
beneficial for all funds, including those that are small entities.
Moreover, with respect to the proposed revisions to the broker-dealer
confirmation requirements of rule 10b-10, we also believe that special
compliance or reporting requirements for small broker-dealers would not
be appropriate or consistent with investor protection, because
distinguishing such requirements based on the size of the broker-dealer
may be accompanied by disparate treatment of investors and could lead
to investor confusion.
For these reasons, we have not proposed alternatives to the
proposed rule and rule and form amendments.
G. Request for Comments
We encourage the submission of comments with respect to any aspect
of the IRFA.
We particularly request comments on the number of, and the
likely impact on, small entities that would be subject to the proposed
rule, and rule and form amendments. Commenters are asked to describe
the nature of any impact and provide empirical data supporting its
extent. These comments will be considered in connection with any
adoption of the proposed rule and amendments, and reflected in a Final
Regulatory Flexibility Analysis.
Comments should be submitted in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090. Comments also may be submitted
electronically to the following e-mail address: [email protected].
All comment letters should refer to File No. S7-15-10, and this file
number should be included on the subject line if e-mail is used.\569\
Comment letters will be available for Web site viewing and printing in
the Commission's Public Reference Room, 100 F Street, NE., Washington,
DC 20549-1520, on official business days between the hours of 10 a.m.
and 3 p.m. Electronically submitted comment letters also will be posted
on the Commission's Internet Web site (http://www.sec.gov).
---------------------------------------------------------------------------
\569\ Comments on the IRFA will be placed in the same public
file that contains comments on the proposed rule and amendments.
---------------------------------------------------------------------------
VII. Consideration of Burden on Competition and Promotion of
Efficiency, Competition and Capital Formation
Section 23(a)(2) of the Exchange Act requires the Commission, in
adopting rules under the Exchange Act, to consider the impact that any
new rule would have on competition, and prohibits the Commission from
adopting any rule that would impose a burden on competition not
necessary or appropriate in furtherance of the purposes of the Exchange
Act.\570\ Section 2(b) of the Securities Act and
[[Page 47131]]
section 3(f) of the Exchange Act require the Commission, when engaging
in rulemaking that requires it to consider or determine whether an
action is necessary or appropriate in the public interest to consider,
in addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation.\571\ Further,
section 2(c) of the Investment Company Act requires the Commission,
when engaging in rulemaking that requires it to consider or determine
whether an action is consistent with the public interest, to consider,
in addition to the protection of investors, whether the action will
promote efficiency, competition, and capital formation.\572\ As
discussed below, we expect that the proposed rule, and rule and form
amendments, may promote efficiency, competition, and capital formation.
---------------------------------------------------------------------------
\570\ 15 U.S.C. 78w(a)(2).
\571\ 15 U.S.C. 77b(b); 15 U.S.C. 78c(f).
\572\ 15 U.S.C. 80a-2(c).
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A. Removal of Rule 12b-1
Our proposal would remove rule 12b-1, and in so doing, would
eliminate the explicit requirements in the rule for board approval and
annual review of asset-based distribution fees and written 12b-1 plans.
By eliminating these formal requirements in rule 12b-1, our proposal is
designed to modify the regulations governing these fees to reflect
current economic realities. As discussed in Section V above, funds may
realize significant time and expense savings when managing asset-based
distribution fees under our proposal, compared to the current
requirements of rule 12b-1. Thus, we expect that the proposed removal
of rule 12b-1 would enhance the efficiency of funds in managing and
overseeing the operation and use of asset-based distribution fees.
Many funds use asset-based distribution fees to pay for
distribution costs in a cost-effective manner that allows them to
compete with other investment products. We expect that, in combination
with the rest of our proposal, our proposed removal of rule 12b-1, if
adopted, would not prevent funds from continuing to access the
competitive benefits of paying for distribution through asset-based
fees. Small funds often use asset-based distribution fees as a means of
building their funds and participating in distribution channels that
they might not otherwise be able to access. We have designed our
proposals to allow funds to continue to grow through these means. In
addition, our proposal would allow funds that currently charge 12b-1
fees to continue to deduct these fees on outstanding shares without
significant disruption. Therefore, we do not anticipate that our
proposal to remove rule 12b-1 would affect capital formation or
competition.
B. Rule 12b-2
We are proposing to adopt rule 12b-2 (in combination with the rest
of our proposal) to replace rule 12b-1. Proposed rule 12b-2 would allow
funds to deduct a ``marketing and service fee'' from fund assets, up to
the amount permitted for service fees under NASD Conduct Rule 2830. The
proposed amendments would consider any asset-based distribution fee
that exceeds this amount to be an ``ongoing sales charge'' that would
be separately regulated under our proposed amendments to rule 6c-10, as
discussed below. Proposed rule 12b-2 would not require a ``plan'' or
impose other special board requirements to deduct a marketing and
service fee. As discussed above, we expect that the marketing and
service fee under proposed rule 12b-2 would allow funds to continue to
experience the competitive and capital formation benefits resulting
from a 25 basis point asset-based distribution fee. The limited
conditions associated with the proposed rule should allow funds to
impose these fees in a more efficient way. Because all funds would be
able to rely on the proposed rule, and because we do not expect that
the rule would affect the ability of funds to create distribution
structures that fit their competitive model, we do not believe that the
proposed rulemaking would impact competition significantly. We also do
not anticipate that the proposed rule would significantly encourage or
discourage assets being invested in the capital markets, or in
particular funds, and thus do not expect that there would be a
significant impact on capital formation.
C. Amended Rule 6c-10
Proposed rule 6c-10(b) would treat asset-based distribution fees
deducted in excess of the marketing and service fee as ``ongoing sales
charges.'' The proposal would require that funds convert shares subject
to an ongoing sales charge to a share class without the fee after the
investor has paid cumulative amounts or rates of ongoing sales charges
that equal the fund's front-end load.
We expect that the ongoing sales charge may allow investors to
better understand the costs of distribution they pay, and would reduce
the potential for some long-time investors to subsidize the
distribution costs of other investors in the same fund. Our proposal
therefore may allow investors who are better informed to allocate their
investments more efficiently. The proposed amendments should also
reduce fund intermediary conflicts of interest when advising investors
regarding fund classes that provide different levels of intermediary
compensation based on the period or method for payment of distribution
fees. This might allow fund intermediaries to spend less time managing
these conflicts and instead allocate their resources more efficiently
towards providing better services to investors and increasing
competition among intermediaries. Because all funds would be able to
rely on the proposed rule, and because we do not expect that the rule
would affect the ability of funds to create distribution structures
that fit their competitive model, we do not believe that the proposed
rulemaking would impact competition significantly. We also do not
anticipate that the proposed rule would significantly encourage or
discourage assets being invested in the capital markets, or in
particular funds, and thus do not expect that there would be a
significant impact on capital formation.
In addition, the proposed amendments to rule 6c-10(c) would permit
funds to sell their shares at a price other than a current public
offering price as described in the prospectus, which is otherwise
required by section 22(d). Section 22(d) imposes a significant
restriction on competition and the efficient setting of sales loads for
mutual fund distribution, because it effectively requires dealers to
sell fund shares at the same sales load, regardless of the services
provided or the actual cost of distribution. Currently, all investors
in a particular fund class pay the same costs for distribution when
purchasing shares through a fund intermediary, regardless of the
quality or type of services provided by the intermediary. Our proposal
would allow funds to make available a class of shares that
``unbundles'' the costs of distribution from the fund's operating
expenses. This is designed to give funds and intermediaries new avenues
for competition, by permitting funds and intermediaries to break out
the costs of distribution from other services they provide, and letting
investors choose different levels of service based on their needs,
considering among other things, cost and quality of the services
offered.
Under our proposal, investors would be able to seek out
intermediaries that provide a high level of service, provide simple
execution of fund trades, or provide services that fall somewhere in
the middle. Sales charges would be
[[Page 47132]]
transparent and could be imposed or deducted in a manner and at any
time selected by the investor. We expect that this would enhance
efficiency of capital allocation as well as competition among fund
intermediaries by allowing investors to shop for the pricing structure
that best suits the investor's needs and the marketing choices of the
fund or intermediary.\573\
---------------------------------------------------------------------------
\573\ Some roundtable commenters agreed that the externalization
of asset-based distribution fees could improve competition among
mutual funds. See Comment Letter of Bridgeway Funds, Inc. and
Bridgeway Capital Management, Inc. (July 19, 2007) (``Mutualization
of [12b-1] fees * * * distorts fundamental, free-market economics
and restricts valuable competition in the intermediary channel.'').
---------------------------------------------------------------------------
Funds that take advantage of the exemption would be able to
effectively externalize the distribution of their shares, an approach
that may encourage small funds and new entrants to the market that are
eager to attract dealers that wish to sell shares based on their own
fee schedules. It may also permit these funds to compete better by
reducing their expense ratios (because it would eliminate, at least
with respect to the particular class, ongoing sales charges), while
still charging low or no front-end sales loads. In addition, innovative
distribution models may encourage additional investors to invest in the
capital markets, enhancing capital formation.
An externalized approach could simplify the operations of
intermediaries, allowing them to process transactions more efficiently
based on a single, uniform fee structure. In some cases, it could also
simplify fund operations and fund prospectuses by eliminating the need
to offer multiple classes of shares, further reducing fund expenses,
enhancing the efficiency of distribution, and reducing investor
confusion. This type of structure may also help traditional mutual
funds better compete with other investments, such as exchange-traded
funds (ETFs), which have externalized distribution costs and have been
growing in popularity.\574\
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\574\ In 2009, ETF assets grew 46 percent (from $531 billion to
$777 billion) while traditional equity and bond mutual fund assets
grew 16 percent (from $9.6 trillion to $11.1 trillion). See 2010 ICI
Fact Book, supra note 6, at 9 and 41.
---------------------------------------------------------------------------
The proposed exemption is designed to foster price competition
among fund intermediaries that charge for the sale of mutual funds, and
enhance the efficiency of fund operations and investor choice.
Therefore, as discussed above, we expect that the proposed rule
amendments are likely to enhance efficiency, competition, and capital
formation in the fund marketplace.
D. Disclosure Amendments
Our proposal would amend Forms N-1A, N-SAR, N-3, N-4, and N-6 and
Regulation S-X, to conform them to our proposed treatment of asset-
based distribution fees.\575\ The proposed amendments would improve
disclosure by separately identifying the ``marketing and service fee''
and ``ongoing sales charge'' as individual line items in the fee table
and income statement. The proposed amendments would also streamline
current disclosure regarding asset-based distribution fees by replacing
disclosure made irrelevant by our proposal with more narrowly focused
and precise information regarding asset-based distribution fees. The
proposed disclosure amendments would also replace references to 12b-1
fees in these forms with references to the appropriate rule in our
proposal.
---------------------------------------------------------------------------
\575\ See supra Section III.
---------------------------------------------------------------------------
These proposed changes may allow investors to more efficiently
obtain and manage information about their investments, as well as
reduce the time and cost burdens funds bear in preparing this
information. These proposed amendments may lead to increased efficiency
by enhancing the ability of investors to more specifically identify the
costs of distribution they pay when investing in funds. This
information should promote more efficient allocation of investments by
investors among funds because they may compare and choose funds based
on their costs of distribution and the services provided for these fees
more easily. To the extent that these create efficiencies, this may
result in new investors investing in funds (or existing investors
adding additional capital), and could enhance capital formation, and
the efficiency of investors selecting among funds. Because these
disclosure amendments would apply to all funds, we do not expect that
they would have an impact on competition in the fund marketplace.
E. Rule 11a-3 and Technical Amendments
Our proposal would also make amendments to rule 11a-3 (which
governs the payment of sales loads when making share exchanges within a
fund family) to conform to our proposed treatment of asset-based
distribution fees as sales loads. The proposed amendments would require
funds to credit ongoing sales charges an investor has paid against any
other load owed when the investor exchanges shares within a fund
family. We do not anticipate that these amendments would affect capital
formation or competition, nor would they reduce the efficiency of these
exchanges because they apply to all funds and should not encourage or
discourage investors to invest in the capital markets. We expect that
the proposed amendments may reassure investors that they would not pay
excessive distribution costs when making exchanges within a fund
family, regardless of whether they chose to pay the costs of
distribution front-end, over time, or upon redemption.
Our proposal would also make technical conforming amendments to
rules 17a-8, 17d-3, and 18f-3, to replace references to rule 12b-1 with
references to the appropriate rule regulating asset-based distribution
fees in our proposal. We do not expect that these changes would affect
the operation of funds, or the behavior of investors, fund
intermediaries, or service providers. Therefore, we do not anticipate
that these proposed amendments would impact competition, efficiency, or
capital formation.
F. Rule 10b-10 Amendments
Our proposal further would amend rule 10b-10 to provide broker-
dealer customers with improved information in transaction confirmations
about mutual fund sales charges and about information regarding
callable securities. These proposed amendments may lead to increased
efficiency and competitiveness by enhancing the ability of investors to
more specifically understand information related to their transactions
in these securities, which not only would allow them to correct any
associated errors, but also would help inform their future purchases of
securities of this type and promote investment into securities that
bear lower distribution-related costs.
G. Request for Comment
We request comment on whether the proposed rule and rule
and form amendments, if adopted, would promote efficiency, competition,
and capital formation. We also request comment on any anti-competitive
effects of the proposed amendments. Commenters are requested to provide
empirical data and other factual support for their views, if possible.
VIII. Small Business Regulatory Enforcement Fairness Act
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996 (``SBREFA''), a rule is ``major'' if it results or is
likely to result in:
An annual effect on the economy of $100 million or more;
[[Page 47133]]
A major increase in costs or prices for consumers or
individual industries; or
Significant adverse effects on competition, investment, or
innovation.
If a rule is ``major,'' its effectiveness will generally be delayed
for 60 days pending Congressional review.
We request comment on the potential impact of the proposed
rules and rule amendments on the economy on an annual basis. Commenters
are requested to provide empirical data and other factual support for
their views to the extent possible.
IX. Statutory Authority
The Commission is proposing amendments to rule 6-07 of Regulation
S-X under the authority set forth in section 7 of the Securities Act
[15 U.S.C. 77g] and sections 8 and 38(a) of the Investment Company Act
[15 U.S.C. 80a-8 and 80a-37(a)]. The Commission is proposing amendments
to Schedule 14A under the authority set forth in sections 3(b), 10, 13,
14, 15, 23(a), and 36 of the Securities Exchange Act [15 U.S.C. 78c(b),
78j, 78m, 78n, 78o, 78w(a), and 78mm], and sections 20(a), 30(a), and
38(a) of the Investment Company Act [15 U.S.C. 80a-20(a), 80a-29(a),
and 80a-37(a)].
The Commission is proposing to rescind rule 12b-1 under the
authority set forth in sections 12(b) and 38(a) of the Investment
Company Act [15 U.S.C. 80a-12(b) and 80a-37(a)]. The Commission is
proposing new rule 12b-2 under the authority set forth in sections
12(b) and 38(a) of the Investment Company Act [15 U.S.C. 80a-12(b) and
80a-37(a)]. The Commission is proposing amendments to rule 6c-10 under
the authority set forth in sections 6(c), 12(b), 22(d)(iii), and 38(a)
of the Investment Company Act [15 U.S.C. 80a-6(c), 80a-12(b), 80a-
22(d)(iii), and 80a-37(a)]. The Commission is proposing amendments to
rules 11a-3, 17a-8, 17d-3, and 18f-3 under the authority set forth in
sections 6(c), 11(a), 17(d), 18(i), and 38(a) of the Investment Company
Act [15 U.S.C. 80a-6(c), 80a-11(a), 80a-17(d), 80a-18(i), and 80a-
37(a)]. The Commission is proposing amendments to Exchange Act rule
10b-10 pursuant to the authority conferred by the Exchange Act,
including Sections 10, 17, 23(a), and 36(a)(1) [15 U.S.C. 78j, 78q,
78w(a), and 78mm(a)(1)].
The Commission is proposing amendments to registration Forms N-1A,
N-3, N-4, and N-6 under the authority set forth in sections 6, 7(a),
10, and 19(a) of the Securities Act [15 U.S.C. 77f, 77g(a), 77j, and
77s(a)], and sections 8(b), 24(a), and 30 of the Investment Company Act
[15 U.S.C. 80a-8(b), 80a-24(a), and 80a-29]. The Commission is
proposing amendments to Form N-SAR pursuant to authority set forth in
sections 10(b), 13, 15(d), 23(a), and 36 of the Securities Exchange Act
[15 U.S.C. 78j(b), 78m, 78o(d), 78w(a), and 78mm], and sections 8,
13(c), 24(a), 30, and 38 of the Investment Company Act [15 U.S.C. 80a-
8, 80a-13(c), 80a-24(a), 80a-29, and 80a-37].
List of Subjects
17 CFR Part 210
Accounting, Reporting, and recordkeeping requirements, Securities.
17 CFR Parts 239, 240, and 249
Reporting and recordkeeping requirements, Securities.
17 CFR Parts 270 and 274
Investment companies, Reporting and recordkeeping requirements,
Securities.
Text of Proposed Rules and Form Amendments
For reasons set forth in the preamble, Title 17, Chapter II of the
Code of Federal Regulations is proposed to be amended as follows:
PART 210--FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL
STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF
1934, INVESTMENT COMPANY ACT OF 1940, INVESTMENT ADVISERS ACT OF
1940, AND ENERGY POLICY AND CONSERVATION ACT OF 1975
1. The authority citation for Part 210 continues to read in part as
follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3,
77aa(25), 77aa(26), 77nn(25), 77nn(26), 78(c), 78j-1, 78l, 78m, 78n,
78o(d), 78q, 78u-5, 78w, 78ll, 78mm, 80a-8, 80a-20, 80a-29, 80a-30,
80a-31, 80a-37(a), 80b-3, 80b-11, 7202 and 7262, unless otherwise
noted.
2. The Part 210 heading is revised as set forth above.
3. Section 210.6-07 is amended by revising paragraph 2(f) to read
as follows:
Sec. 210.6-07 Statements of operations.
* * * * *
2. Expenses. * * *
(f) State separately all fees deducted from fund assets to finance
distribution activities pursuant to Sec. Sec. 270.12b-2(b), (d) or
270.6c-10(b) of this chapter. Reimbursement to the fund of expenses
deducted from fund assets pursuant to Sec. Sec. 270.12b-2(b), (d) and
270.6c-10(b) shall be shown as a negative amount and deducted from
current Sec. Sec. 270.12b-2(b), (d) and 270.6c-10(b) expenses. If
Sec. Sec. 270.12b-2(b) and 270.6c-10(b) expense reimbursements exceed
current Sec. Sec. 270.12b-2(b) and 270.6c-10(b) expenses, such excess
shall be used in the calculation of total expenses under this caption.
* * * * *
PART 239--FORMS PRESCRIBED UNDER THE SECURITIES ACT OF 1933
4. The authority citation for Part 239 continues to read, in part,
as follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3,
77sss, 78c, 78l, 78m, 78n, 78o(d), 78u-5, 78w(a), 78ll, 78mm, 80a-
2(a), 80a-3, 80a-8, 80a-9, 80a-10, 80a-13, 80a-24, 80a-26, 80a-29,
80a-30, and 80a-37, unless otherwise noted.
* * * * *
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
5. The general authority citation for Part 240 is revised to read
as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i,
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5,
78w, 78x, 78ll, 78mm, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4,
80b-11, and 7201 et seq.; and 18 U.S.C. 1350, unless otherwise
noted.
6. Section 240.10b-10 is amended by:
a. Revising paragraph (a)(6)(i);
b. Removing from paragraph (a)(9)(ii) the period at the end of the
paragraph and adding in its place ``; and''
c. Adding paragraphs (a)(10) and (a)(11);
d. Revising paragraph (b)(2);
e. Adding paragraph (d)(10);
f. Removing from paragraph (e) introductory text ``, Provided
that:'' at the end and adding in its place ``; provided that the broker
or dealer that effects any transaction for a customer in security
futures products in a futures account gives or sends to the customer no
later than the next business day after execution of any futures
securities product transaction, written notification disclosing:''
g. Removing paragraph (e)(1) introductory text and redesignating
paragraphs (e)(1)(i), (ii), (iii) and (iv) as paragraphs (e)(1), (2),
(3), and (4), respectively; and
h. Removing paragraph (e)(2).
The revisions and additions read as follows.
Sec. 240.10b-10 Confirmation of transactions.
* * * * *
(a) * * *
(6) * * *
(i) The yield at which the transaction was effected, including the
percentage
[[Page 47134]]
amount and its characterization (e.g., current yield, yield to
maturity, or yield to call) and if effected at yield to call, the type
of call, the call date and, if different, the first date upon which the
security may be called, and call price; and
* * * * *
(10) In the case of a purchase of a mutual fund security:
(i) The amount of any sales charge that the customer incurred at
the time of purchase, expressed in dollars and as a percentage of the
public offering price, the net dollar amount invested in the security,
and the amount of any applicable breakpoint or similar threshold used
to calculate the sales charge;
(ii) The maximum amount of any deferred sales charge that the
customer may incur in connection with the subsequent redemption or sale
of the securities purchased, expressed as a percentage of the net asset
value at the time of purchase or at the time of redemption or sale, as
applicable;
(iii) If the customer will incur any ongoing sales charge (as
defined in Sec. 270.6c-10) or any marketing and service fee (as
defined in Sec. 270.12b-2) after the time of purchase:
(A) The annual amount of the charge or fee, expressed as a
percentage of net asset value; the aggregate amount of the ongoing
sales charge that may be incurred over time, expressed as a percentage
of net asset value; and the maximum number of months or years that the
customer will incur ongoing sales charge; and
(B) The following statement (which may be revised to reflect the
particular charge or fee at issue): ``In addition to ongoing sales
charges and marketing and service fees, you will also incur additional
fees and expenses in connection with owning this mutual fund, as set
forth in the fee table in the mutual fund prospectus; these typically
will include management fees and other expenses. Such fees and expenses
are generally paid from the assets of the mutual fund in which you are
investing. Therefore, these costs are indirectly paid by you.''; and
(11) In the case of a redemption or sale of a mutual fund security,
the amount of any deferred sales charge that the customer has paid in
connection with the redemption or sale, expressed in dollars and as a
percentage of the net asset value at the time of purchase or at the
time of redemption or sale, as applicable.
(b) * * *
(2) Such broker or dealer gives or sends to such customer within
five business days after the end of each quarterly period, for
transactions involving investment company and periodic plans, and after
the end of each monthly period, for other transactions described in
paragraph (b)(1) of this section, a written statement disclosing each
purchase or redemption, effected for or with, and each dividend or
distribution credited to or reinvested for, the account of such
customer during the month; the date of such transaction; the identity,
number, and price of any securities purchased or redeemed by such
customer in each such transaction; the total number of shares of such
securities in such customer's account; any remuneration received or to
be received by the broker or dealer in connection therewith; any
ongoing sales charges or marketing and service fees incurred in
connection with the purchase or redemption of a mutual fund security;
and that any other information required by paragraph (a) of this
section will be furnished upon written request: Provided, however, that
the written statement may be delivered to some other person designated
by the customer for distribution to the customer; and
* * * * *
(d) * * *
(10) Mutual fund security means any security issued by an open-end
company, as defined by section 5(a)(1) of the Investment Company Act of
1940 (15 U.S.C. 80a-5(a)(1)), that is registered or required to
register under section 8 of that Act, including any series of such
company.
* * * * *
7. Schedule 14A (referenced in Sec. 240.14a-101) is amended by
revising paragraphs (a)(1)(iii) and (d) in Item 22 to read as follows:
Sec. 240.14a-101 Schedule 14A Information required in a proxy
statement.
* * * * *
Item 22. Information Required in Investment Company Proxy Statement
(a) * * *
(1) * * *
(iii) Marketing and Service Fee. The term ``Marketing and Service
Fee'' shall mean a fee deducted from Fund assets to finance
distribution activities pursuant to rule 12b-2(b) (Sec. 270.12b-2(b)).
* * * * *
(d) Marketing and Service Fees. If action is to be taken to
institute a Marketing and Service Fee or increase the rate of an
existing Marketing and Service Fee, include the following information
in the proxy statement:
(1) A description of the nature of the action to be taken and the
reasons therefore, the rate of the Marketing and Service Fee as it is
proposed to be deducted and the purposes for which such fee may be
used, and, if the action to be taken is an increase in the rate of an
existing Marketing and Service Fee, the reasons for the increase.
(2) If the Fund currently deducts a Marketing and Service Fee:
(i) Provide the date that the Marketing and Service Fee was first
instituted and the date of the last increase, if any;
(ii) Disclose the rate of the Marketing and Service Fee and the
purposes for which such fee may be used; and
(iii) Disclose the name of, and the amount of any Marketing and
Service Fee paid by the Fund during its most recent fiscal year to, any
person who is an affiliated person of the Fund, its investment adviser,
principal underwriter, or Administrator, an affiliated person of such
person, or a person that during the most recent fiscal year received
10% or more of the aggregate amount of Marketing and Service Fees paid
by the Fund.
* * * * *
PART 249--FORMS, SECURITIES EXCHANGE ACT OF 1934
8. The authority citation for Part 249 continues to read, in part,
as follows:
Authority: 15 U.S.C. 78a et seq. and 7201 et seq.; and 18
U.S.C. 1350, unless otherwise noted.
* * * * *
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
9. The general authority citation for Part 270 continues to read in
part as follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.
10. The authority citation for Sec. 270.6c-10 is revised to read
as follows:
Authority: * * *
Section 270.6c-10 is also issued under 15 U.S.C. 80a-6(c), 15
U.S.C. 80a-12(b), 15 U.S.C. 80a-22(d) and 80a-37(a).
* * * * *
11. The authority citation for Sec. 270.12b-2 is added to read as
follows:
Authority: * * *
* * * * *
Section 270.12b-2 is also issued under 15 U.S.C. 80a-6(c), 15
U.S.C. 80a-12(b), and 80a-37(a).
* * * * *
12. The authority citation for Sec. 270.17a-8 continues to read as
follows:
[[Page 47135]]
Authority: * * *
* * * * *
Section 270.17a-8 is also issued under 15 U.S.C. 80a-6(c) and
80a-37(a).
* * * * *
13. Section 270.6c-10 is revised to read as follows:
Sec. 270.6c-10 Exemptions for certain open-end management investment
companies to impose deferred sales loads and other sales charges.
(a) Deferred Sales Load. (1) Exemption. Notwithstanding sections
2(a)(32), 2(a)(35), and 22(d) of the Act [15 U.S.C. 80a-2(a)(32), 80a-
2(a)(35), and 80a-22(d), respectively] and Sec. 270.22c-1, a fund,
other than a registered separate account, and any exempted person may
impose a deferred sales load on fund shares, if:
(i) The amount of the deferred sales load does not exceed a
specified percentage of the net asset value or the offering price at
the time of purchase; and
(ii) The terms of the deferred sales load are covered by the
provisions of Rule 2830 of the Conduct Rules of the NASD; and
(iii) The same deferred sales load is imposed on all shareholders,
except that a fund may offer scheduled variations in or elimination of
a deferred sales load to a particular class of shareholders or
transactions if the fund has satisfied the conditions in Sec. 270.22d-
1.
(2) Load Reductions. Nothing in this paragraph (a) prevents a fund
from offering to existing shareholders a new scheduled variation that
would waive or reduce the amount of a deferred sales load not yet paid.
(b) Fund-Level Sales Charge. (1) Exemption. Notwithstanding Sec.
270.12b-2(b)(1), 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,
provided that:
(i) A fund may satisfy the requirements of this paragraph (b) if
shares subject to an ongoing sales charge convert (without any
shareholder action and in accordance with Sec. 270.18f-3(f)(2)) to a
fund share class without an ongoing sales charge, on or before the end
of the conversion period;
(ii) Shares acquired by reinvestment of dividends or other
distributions may be invested in a fund share class with an ongoing
sales charge only if the reinvested shares convert to a share class
without an ongoing sales charge no later than when the shares on which
the dividend or distribution was declared convert;
(iii) A fund may offer scheduled variations in the conversion
period to a particular class of shareholders or transactions if the
fund has satisfied the conditions in Sec. 270.22d-1; and
(iv) The fund does not acquire shares of another fund that, with
respect to the class of shares acquired, deducts an ongoing sales
charge.
(2) Sales Charge Reductions. Nothing in this paragraph (b) prevents
a fund from offering to existing shareholders a new scheduled variation
that would reduce the conversion period.
(3) Changes to Ongoing Sales Charge. No fund may:
(i) Institute or increase the rate of an ongoing sales charge
applied to a fund share class or series 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; or
(ii) Increase the amount of time after which a share class will
automatically convert to a class of shares that does not have an
ongoing sales charge, if it would increase the cumulative amount of
ongoing sales charges imposed.
(c) Account-Level Sales Charge. Notwithstanding section 22(d) of
the Act [15 U.S.C. 80a-22(d)], any fund class and any exempted person
may offer or sell fund shares at a price other than the current public
offering price described in the prospectus, if:
(1) The class does not impose an ongoing sales charge pursuant to
Sec. 270.6c-10(b), although it may impose a marketing and service fee
pursuant to Sec. 270.12b-2(b); and
(2) The fund discloses in its registration statement that it has
elected to rely on this paragraph (c) for an exemption from section
22(d) of the Act [15 U.S.C. 80a-22(d)].
(d) Definitions. For purposes of this section:
(1) Acquired security has the same meaning as in Sec. 270.11a-
3(a)(1).
(2) Conversion period is the period beginning on the day that
shares are purchased and ending on the last day of the calendar month
during which the cumulative ongoing sales charge rates exceed the
shareholder's maximum sales load rate. The maximum number of months in
a conversion period is determined by dividing the shareholder's maximum
sales load rate by the ongoing sales charge rate and multiplying the
result by 12.
(3) Deferred sales load means any amount properly chargeable to
sales or promotional expenses that is paid directly by a shareholder to
a fund after purchase but before or upon redemption.
(4) Distribution activity means any ``Distribution activity,'' as
defined in Sec. 270.12b-2(e)(2).
(5) Exchanged security has the same meaning as in Sec. 270.11a-
3(a)(4).
(6) Exempted person means any principal underwriter of, dealer in,
and any other person authorized to effect transactions in, shares of a
fund.
(7) Fund means a registered open-end management investment company,
and includes a separate series of a fund.
(8) Group of investment companies has the same meaning as in Sec.
270.11a-3(a)(5).
(9) Maximum sales load means the maximum sales load rate multiplied
by the total dollar amount paid.
(10) Maximum sales load rate means the reference load minus the sum
of the rates of:
(i) Any sales load (including a deferred sales load) incurred in
connection with the purchase of fund shares; and
(ii) Any sales loads or ongoing sales charges previously paid with
respect to an exchanged security within the same group of investment
companies.
(11) Ongoing sales charge means any charges or fees deducted from
fund assets to finance distribution activity in excess of the maximum
rate permitted under Sec. 270.12b-2(b). In the case of a fund (``the
acquiring fund'') that acquires shares of another fund (the ``acquired
fund''), ongoing sales charge means any charges or fees deducted from
fund assets to finance distribution activity in excess of the acquiring
fund's marketing and service fee (as defined in Sec. 270.12b-2(e)(3)),
without regard to any acquired fund's marketing and service fee.
(12) Ongoing sales charge rate is the annual ongoing sales charge,
expressed as a percentage of net asset value.
(13) Organizers of a fund means any affiliated person of the fund,
any affiliated person of such person, any promoter of the fund, and any
affiliated person of such promoter.
(14) Reference load means:
(i) The highest sales load rate that the shareholder would have
paid if, at the time of the purchase of fund shares, the shareholder
had purchased a class offered by the fund that does not have an ongoing
sales charge and for which the shareholder qualifies according to the
fund's registration statement;
(ii) In the case of shares exchanged within the same group of
investment companies, the highest applicable sales load rate of the
acquired security or the exchanged security; or
(iii) If no reference load can be determined under paragraphs
(d)(14)(i) or (d)(14)(ii) of this section, the reference load is the
maximum sales charge rate permitted a fund that deducts an asset-based
sales charge and
[[Page 47136]]
a service fee under Rule 2830(d)(2)(A) of the Conduct Rules of the
NASD.
(15) Sales load rate is the sales load expressed as a percentage of
the fund share offering price.
14. Section 270.11a-3 is amended by revising paragraphs (b)(4) and
(b)(5)(i)(A) and (b)(5)(ii)(A) to read as follows:
Sec. 270.11a-3 Offers of exchange by open-end investment companies
other than separate accounts.
* * * * *
(b) * * *
(4) Any sales load charged with respect to the acquired security is
a percentage that is no greater than the excess, if any, of the rate of
the sales load applicable to that security in the absence of an
exchange over the sum of the rates of all sales loads and ongoing sales
charges (as permitted under Sec. 270.6c-10(b)), previously paid on the
exchanged security, Provided that:
(i) The percentage rate of any sales load charged when the acquired
security is redeemed, that is solely the result of a deferred sales
load imposed on the exchanged security, may be no greater than the
excess, if any, of the applicable rate of such sales load, calculated
in accordance with paragraph (b)(5) of this section, over the sum of
the rates of all ongoing sales charges and sales loads previously paid
on the acquired security, and
(ii) In no event may the sum of the rates of all ongoing sales
charges and sales loads imposed prior to and at the time the acquired
security is redeemed, including any ongoing sales charges and sales
load paid or to be paid with respect to the exchanged security, exceed
the maximum sales load rate, calculated in accordance with paragraph
(b)(5) of this section, that would be applicable in the absence of an
exchange to the security (exchanged or acquired) with the highest such
rate;
(5) * * *
(i) * * *
(A) Reduced by the sum of the rates of all ongoing sales charges
collected on the acquired security pursuant to Sec. 270.6c-10(b), and
* * * * *
(ii) * * *
(A) The deferred sales load is reduced by the sum of the rates of
all ongoing sales charges previously collected on the exchanged
security pursuant to Sec. 270.6c-10(b), and
* * * * *
Sec. 270.12b-1 [Removed]
15. Section 270.12b-1 is removed.
16. Section 270.12b-2 is added to read as follows:
Sec. 270.12b-2 Investment company distribution fees.
(a) Preliminary Matters. (1) Except as provided in this section, it
is unlawful for any fund (other than a fund complying with the
provisions of section 10(d) of the Act [15 U.S.C. 80a-10(d)]) to act as
a distributor of securities of which it is the issuer, except through
an underwriter.
(2) For purposes of this section, a fund will be deemed to be
acting as a distributor of securities of which it is the issuer, other
than through an underwriter, if it directly or indirectly uses fund
assets to finance any distribution activity.
(b) Marketing and Service Fee. A fund may use fund assets to
finance distribution activity, provided that, with regard to any class
of the fund:
(1) All charges and fees deducted from fund assets to finance
distribution activity do not exceed the maximum rate of the service fee
allowed under Rule 2830 of the NASD Conduct Rules, except as permitted
by Sec. 270.6c-10(b);
(2) If a fund (the ``acquiring fund'') acquires shares of another
fund (the ``acquired fund''), the combined rate of the marketing and
service fees of the acquiring fund and any acquired fund to finance
distribution activities does not exceed the maximum rate permitted in
paragraph (b)(1) of this section.
(3) The marketing and service fee (or any increase in the rate of
such a fee) has been approved by a vote of at least a majority of the
fund's outstanding voting securities if the fee is instituted or
increased after any public offering of the fund's voting securities or
the sale of such securities to persons who are not affiliated persons
of the company, affiliated persons of such persons, promoters of the
fund, or affiliated persons of such promoters.
(c) Directed Brokerage. Notwithstanding any other provision of this
section, a fund may not:
(1) Compensate a broker or dealer for any promotion or sale of
shares issued by that fund by directing to the broker or dealer:
(i) The fund's portfolio securities transactions; or
(ii) Any remuneration, including but not limited to any commission,
mark-up, mark-down, or other fee (or portion thereof) received or to be
received from the fund's portfolio transactions effected through any
other broker (including a government securities broker) or dealer
(including a municipal securities dealer or a government securities
dealer); and
(2) Direct its portfolio securities transactions to a broker or
dealer that promotes or sells shares issued by the fund, unless the
fund (or its investment adviser):
(i) Is in compliance with the provisions of paragraph (c)(1) of
this section with respect to that broker or dealer; and
(ii) Has implemented, and the fund's board of directors (including
a majority of directors who are not interested persons of the fund) has
approved, policies and procedures reasonably designed to prevent:
(A) The persons responsible for selecting brokers and dealers to
effect the fund's portfolio securities transactions from taking into
account the brokers' and dealers' promotion or sale of shares issued by
the fund or any other registered investment company; and
(B) The fund, and any investment adviser and principal underwriter
of the fund, from entering into any agreement (whether oral or written)
or other understanding under which the fund directs, or is expected to
direct, portfolio securities transactions, or any remuneration
described in paragraph (c)(1)(ii) of this section, to a broker
(including a government securities broker) or dealer (including a
municipal securities dealer or a government securities dealer) in
consideration for the promotion or sale of shares issued by the fund or
any other registered investment company.
(d) Grandfathered Rule 12b-1 Fees. Until [date 5 years after
compliance date of the rule], notwithstanding any other provision in
this section, a fund may act as a distributor of securities sold prior
to [the compliance date of rule 12b-2] subject to a rule 12b-1 plan
approved under Sec. 270.12b-1 (2010 version) as in effect prior to
[the compliance date of rule 12b-2], provided that:
(1) The fund's board of directors may vote to eliminate the
provisions in the fund's rule 12b-1 plan that were required by
paragraphs (b)(3)(i) (annual approval), (b)(3)(ii) (quarterly reports)
and (b)(3)(iii) (termination) of Sec. 270.12b-1 (2010 version);
(2) With regard to any class of the fund, the fund does not
increase the annual rate of the fee paid under its rule 12b-1 plan in
the most recent fiscal year, and
(3) As of [date 5 years after compliance date of the final rule]
all securities subject to paragraph (d) of this section must be
exchanged or converted into securities of a class that does not deduct
an ongoing sales charge as defined in Sec. 270.6c-10(d)(11) and that
does not charge a marketing and service fee in excess of the annual
rate of the fee paid under its rule 12b-1 plan in the most recent
fiscal year.
[[Page 47137]]
(e) Definitions. For purposes of this section:
(1) Fund means a registered open-end management investment company,
and includes a separate series of the fund.
(2) Distribution activity means 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.
(3) Marketing and Service Fee means any charges or fees deducted
from fund assets under paragraph (b)(1) of this section.
17. Section 270.17a-8 is amended by revising paragraph (a)(3)(iv)
to read as follows:
Sec. 270.17a-8 Mergers of affiliated companies.
(a) * * *
(3) * * *
(iv) Any distribution fees (as a percentage of the fund's average
net assets) authorized to be paid by the surviving company pursuant to
provisions of Sec. 270.12b-2(b) or (d) or Sec. 270.6c-10(b), are no
greater than the distribution fees (as a percentage of the fund's
average net assets) authorized to be paid by the merging company.
* * * * *
18. Section 270.17d-3 is amended by revising paragraph (a) to read
as follows:
Sec. 270.17d-3 Exemption relating to certain joint enterprises or
arrangements concerning payment for distribution of shares of a
registered open-end management investment company.
* * * * *
(a) Such agreement is made in compliance with the provisions of
Sec. 270.12b-2(b) or (d) or Sec. 270.6c-10(b); and
* * * * *
19. Section 270.18f-3 is amended by revising paragraph (f)(2)(ii)
to read as follows:
Sec. 270.18f-3 Multiple class companies.
* * * * *
(f) * * *
(2) * * *
(ii) The expenses, including distribution payments authorized under
Sec. 270.12b-2(b) or (d) or Sec. 270.6c-10(b), for the target class
are not higher than the expenses, including distribution payments
authorized under Sec. 270.12b-2(b) or (d) or Sec. 270.6c-10(b), for
the purchase class; and
* * * * *
PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940
20. The authority citation for Part 274 continues to read in part
as follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m,
78n, 78o(d), 80a-8, 80a-24, 80a-26, and 80a-29, unless otherwise
noted.
* * * * *
21. Form N-1A (referenced in Sec. Sec. 239.15A and 274.11A) is
amended by:
a. Adding the definition ``asset-based distribution fee'' in
alphabetical order to General Instructions A;
b. Revising the ``Annual Fund Operating Expenses'' fee table and
Instruction 3(b) to Item 3;
c. Revising paragraph b and removing the Instruction to paragraph b
of Item 12;
d. Revising paragraph g and adding an Instruction to paragraph g of
Item 19;
e. Adding paragraph d to item 25;
f. Revising Instruction 5 to paragraph (b)(4) of Item 26;
g. In the expense example in paragraph (d)(1) of Item 27, removing
the reference to ``distribution [and/or service](12b-1) fees'' and
adding in its place ``asset-based distribution fees'';
h. In Instruction 2(a)(i) following paragraph (d)(1) to Item 27,
removing the reference to ``Distribution [and/or service](12b-1) fees''
and adding in its place ``asset-based distribution fees''; and
i. Removing and reserving paragraph (m) of Item 28.
The revisions read as follows:
Note: The text of Form N-1A does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form N-1A
* * * * *
General Instructions
A. Definitions
* * * * *
------``Asset-Based Distribution Fee'' means a fee deducted from Fund
assets to finance distribution activities pursuant to rule 12b-2(b) (17
CFR 270.12b-2(b)) (``Marketing and Service Fee''), rule 12b-2(d) (17
CFR 270.12b-2(d)), and/or rule 6c-10(b) (17 CFR 270.6c-10(b))
(``Ongoing Sales Charge'').
* * * * *
Item 3. Risk/Return Summary: Fee Table
* * * * *
Annual Fund Operating Expenses (expenses that you pay each year as
a percentage of the value of your investment).
Management Fees........................................... ----%
Ongoing Sales Charge...................................... ----%
Other Expenses............................................ ----%
Marketing and Service Fee............................... ----%
----%
----%
Total Annual Fund Operating Expenses...................... ----%
* * * * *
Instructions.
* * * * *
3. Annual Fund Operating Expenses
* * * * *
(b) ``Ongoing Sales Charge'' includes all expenses incurred during
the most recent fiscal year pursuant to rule 6c-10(b) (17 CFR 270.6c-
10(b)). ``Marketing and Service Fee'' includes all expenses incurred
during the most recent fiscal year pursuant to rule 12b-2(b) (17 CFR
270.12b-2(b)).
* * * * *
Item 12. Distribution Arrangements
* * * * *
(b) Asset-Based Distribution Fees. If the Fund deducts an Asset-
Based Distribution Fee, state separately the rate of Ongoing Sales
Charges, Marketing and Service Fees, or fees charged pursuant to rule
12b-2(d) (17 CFR 270.12b-2(d)), as applicable, and state each one's
purpose and general terms, and provide disclosure to the following
effect:
(1) The Fund deducts a fee for the sale and distribution of its
shares and, if applicable, for services provided to fund investors. If
the Fund deducts a fee for such services, describe the nature and
extent of services provided to fund investors.
(2) For Multiple Class Funds that offer more than one Class in the
prospectus, discuss the general circumstances under which an investment
in a Class that deducts an Asset-Based Distribution Fee may be more or
less advantageous than an investment in a Class that either does not
deduct an Asset-Based Distribution Fee or a Class that deducts a
different Asset-Based Distribution Fee. Include the effect of different
holding periods and investment amounts in this description.
(3) For Funds that deduct an Ongoing Sales Charge, the number of
months/years that an investor's shares would be subject to the charge
before automatically converting to a Class without such a deduction.
* * * * *
Item 19. Investment Advisory and Other Services
* * * * *
(g) Asset-Based Distribution Fees. If the Fund deducts an Asset-
Based
[[Page 47138]]
Distribution Fee, provide a description of the fee(s) and how they are
used, including a list of the principal types of activities for which
payments are or will be made (e.g., advertising; printing and mailing
of prospectuses to other than current shareholders; compensation to
underwriters, compensation to broker-dealers, shareholder servicing
fees, etc.).
Instruction. If a Fund offers a Class that deducts both an Ongoing
Sales Charge and a Marketing and Service Fee, separate the list of
activities according to type of fee.
* * * * *
Item 25. Underwriters
* * * * *
(d) If the fund has elected to rely on rule 6c-10(c) (17 CFR Sec.
270.6c-10(c)) to permit the fund or its underwriter to distribute
shares at a price other than a current public offering price described
in the prospectus, state that the fund has made this election.
* * * * *
Item 26. Calculation of Performance Data
* * * * *
(b) * * *
(4) * * *
Instructions.
* * * * *
5. Include expenses accrued due to any Asset-Based Distribution
Fees owed in the expenses accrued for the period. Reimbursement accrued
may reduce the accrued expenses, but only to the extent the
reimbursement does not exceed expenses accrued for the period.
* * * * *
Item 28. Exhibits
* * * * *
(m) Reserved.
* * * * *
22. Form N-3 (referenced in Sec. Sec. 239.17a and 274.11b) is
amended by:
a. Revising Instruction 2 to Item 7(a);
b. Revising paragraph (f) and the Instruction to paragraph (f) of
Item 21;
c. Revising Instruction 5 to Item 26(b)(ii).
The revisions read as follows:
Note: The text of Form N-3 does not, and this amendment will
not, appear in the Code of Federal Regulations.
Form N-3
* * * * *
Item 7. Deductions and Expenses
(a) * * *
Instructions.
* * * * *
2. If proceeds from explicit sales loads will not cover the
expected costs of distributing the contracts, identify from what source
the shortfall, if any, will be paid. If any shortfall is to be made up
from assets from the Insurance Company's general account, disclose, if
applicable, that any amounts paid by the Insurance Company may consist,
among other things, of proceeds derived from mortality and expense risk
charges deducted from the account. If Registrant directly or indirectly
pays any asset-based distribution expenses under rule 12b-2(b) (17 CFR
270.12b-2(b)), rule 12b-2(d) (17 CFR 270.12b-2(d)), or rule 6c-10(b)
(17 CFR 270.6c-10(b)), provide a description of the expenses and list
the principal types of activities for which payments are made.
* * * * *
Item 21. Investment Advisory and Other Services
* * * * *
(f) If the Registrant deducts any asset-based distribution fees
under rule 12b-2(b) (Sec. 270.12b-2(b)), rule 12b-2(d) (17 CFR
270.12b-2(d)), or rule 6c-10(b) (17 CFR 270.6c-10(b)), provide a
description of the fee(s) and how they are used, including a list of
the principal types of activities for which payments are or will be
made (e.g., advertising; printing and mailing of prospectuses to other
than current shareholders; compensation to underwriters, compensation
to broker-dealers, shareholder servicing fees, etc.).
Instruction. If a Registrant deducts both an ongoing sales charge
and a marketing and service fee, separate the list of activities
according to type of fee.
* * * * *
Item 26. Calculation of Performance Data
* * * * *
(b) * * *
(ii) * * *
* * * * *
Instructions.
* * * * *
5. Include all asset-based distribution expenses accrued under rule
12b-2(b) (17 CFR 270.12b-2(b)), rule 12b-2(d) (17 CFR 270.12b-2(d)),
and rule 6c-10(b) (17 CFR 270.6c-10(b)) among the expenses accrued for
the period. Reimbursement of expenses deducted from fund assets
pursuant to rule12b-2(b) (17 CFR 270.12b-2(b)), rule 12b-2(d) (17 CFR
270.12b-2(d)), and rule 6c-10(b) (17 CFR 270.6c-10(b)) may reduce the
accrued expenses, but only to the extent the reimbursement does not
exceed expenses accrued for the period.
* * * * *
23. Form N-4 (referenced in Sec. Sec. 239.17b and 274.11c) is
amended by:
a. In the ``Total Annual [Portfolio Company] Operating Expenses''
table in Item 3(a), removing the reference to ``distribution [and/or
service](12b-1) fees'' and adding in its place ``asset-based
distribution fees.''
b. In Instruction 16 to Item 3 adding a definition of ``asset-based
distribution fees.''
The addition reads as follows:
Note: the text of Form N-4 does not, and these amendments will
not, appear in the Code of Federal Regulations.
Form N-4
* * * * *
Item 3. Synopsis
* * * * *
16. ``Management Fees'' include investment advisory fees (including
any component thereof based on the performance of the portfolio
company), any other management fees payable by the portfolio company to
the investment adviser or its affiliates, and administrative fees
payable to the investment adviser or its affiliates not included as
``Other Expenses.'' ``Asset-based distribution fee'' includes all
asset-based distribution expenses paid under rule 12b-2(b) (17 CFR
270.12b-2(b)), rule 12b-2(d) (17 CFR 270.12b-2(d)), and rule 6c-10(b)
(17 CFR 270.6c-10(b)).
* * * * *
24. Form N-6 (referenced in Sec. Sec. 239.17c and 274.11d) is
amended by:
a. In the ``Total Annual [Portfolio Company] Operating Expenses''
table in Item 3, removing the reference to ``distribution [and/or
service](12b-1) fees'' and adding in its place ``asset-based
distribution fees.''
b. Adding paragraph (g) to Instruction 4 of Item 3.
The addition reads as follows:
Note: The text of Form N-6 does not, and these amendments will
not, appear in the Code of Federal Regulations.
.Form N-6
* * * * *
Item 3. Risk/Benefit Summary: Fee Table
* * * * *
Instructions.
* * * * *
(4) * * *
(g) ``Asset-based distribution fee'' includes all asset-based
distribution expenses paid under rule 12b-2(b) (17 CFR 270.12b-2(b)),
rule 12b-2(d) (17 CFR 270.12b-2(d)), and rule 6c-10(b) (17 CFR 270.6c-
10(b)).
* * * * *
[[Page 47139]]
25. Form N-SAR (referenced in Sec. Sec. 249.330 and 274.101) is
amended by:
a. Revising Item 40 in Instructions to Specific Items;
b. Removing Items 41-44 in Instructions to Specific Items; and
c. Removing the last sentence in the Instruction to Sub-Item 72DD2
in Instructions to Specific Items.
The revision reads as follows:
Note: The text of Form N-6 does not, and these amendments will
not, appear in the Code of Federal Regulations.
Form N-SAR
* * * * *
Instructions to Specific Items
* * * * *
Item 40: Plans Adopted Pursuant to Former Rule 12b-1
Rule 12b-1 under the Act (17 CFR 270.12b-1), has been rescinded.
Registrants that have grandfathered 12b-1 share classes pursuant to
rule 12b-2(d) (17 CFR 270.12b-2(d)), should answer this question
``Yes.'' Registrants that do not have grandfathered 12b-1 share classes
pursuant to rule 12b-2(d) under the Act should answer this question
``No.''
Dated: July 21, 2010.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2010-18305 Filed 8-3-10; 8:45 am]
BILLING CODE 8010-01-P