[Federal Register: August 4, 2010 (Volume 75, Number 149)]
[Proposed Rules]
[Page 47063-47139]
[DOCID:fr04au10-19]

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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

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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_ADDRESS>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<PHONE_NUMBER>, 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

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

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

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'').
---------------------------------------------------------------------------

    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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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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.'').
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \75\ NASD Conduct Rule 2830(d)(5).
    \76\ See 1992 NASD Rule Release, supra note 66, at section
III.A.
---------------------------------------------------------------------------

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\

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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

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

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

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

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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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\
---------------------------------------------------------------------------

    \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

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