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SEC proposes regulation of distribution fees and enhanced disclosure

The Securities and Exchange Commission today voted unanimously to propose measures aimed to improve the regulation of mutual fund distribution fees and provide better disclosure for investors.

The marketing and selling costs involved with running a mutual fund are commonly referred to as a fund's distribution costs. To cover these costs, the companies that run mutual funds are permitted to charge fees known as 12b-1 fees. These fees are deducted from a mutual fund to compensate securities professionals for sales efforts and services provided to the fund's investors.

12b-1 fees were developed in the late 1970s when funds were losing investor assets faster than they were attracting new assets, and self-distributed funds were emerging in search of ways to pay for necessary marketing expenses. These fees amounted to an aggregate of just a few million dollars in 1980 when they were first permitted, but that total has ballooned as the use of 12b-1 fees has evolved. These fees amounted to $9.5 billion in 2009.

"Despite paying billions of dollars, many investors do not understand what 12b-1 fees are, and it's likely that some don't even know that these fees are being deducted from their funds or who they are ultimately compensating," said SEC Chairman Mary L. Schapiro. "Our proposals would replace rule 12b-1 with new rules designed to enhance clarity, fairness and competition when investors buy mutual funds."

The SEC's proposal would:

  • Protect investors by limiting fund sales charges.
  • Improve transparency of fees for investors.
  • Encourage retail price competition.
  • Revise fund director oversight duties.

There will be a 90-day public comment period after the SEC's proposal is published in the Federal Register.



The Securities and Exchange Commission today voted to propose a new and more equitable framework governing the way in which mutual funds are marketed and sold to investors. In particular, the proposed changes would replace existing provisions, including Rule 12b-1, that allow mutual funds to use their assets to compensate securities professionals who sell shares of the fund.


As with any business, running a mutual fund involves costs, including the costs of marketing and selling the fund to prospective investors. These marketing and selling costs are commonly referred to as a fund's distribution costs.

To cover these costs, the companies that run mutual funds are permitted to charge fees, known as 12b-1 fees. These fees are deducted from mutual funds to compensate securities professionals for sales efforts and for services provided to the mutual fund investors.

But, many investors are unaware that these fees are being deducted and are unaware who these fees are ultimately compensating. Nor may they realize that the amounts the fund spends for such costs directly reduce the value of the investors' shares of the fund.

Last December, SEC Chairman Mary Schapiro stated, "When it comes to these fees, there is a need for more fundamental change than merely disclosure reforms and a name change. We must critically rethink how 12b-1 fees are used and whether they continue to be appropriate. For example, do they result in investors overpaying for services or paying for distribution services that they may not even know they are supposed to be getting?"

In 2009, these fees amounted to $9.5 billion and exceeded $13 billion in 2007 — compared to just a few million dollars in 1980 when they were first permitted.

Today, the Commission will consider proposing rules to provide a new framework governing how mutual fund companies collect fees to cover the costs of marketing and selling mutual funds.

  • The proposal would:

Protect Investors by Limiting Fund Sales Charges

Limiting "Ongoing Sales Charges": When an investor buys shares of a mutual fund, there is frequently an accompanying sales charge (or load) that compensates the broker-dealer who helped sell the shares. The charge can be paid up front or over time. Typically, different "classes" of a fund involve different sales charge arrangements.

Front-end sales charge: A "front-end" sales charge is paid up front when the investor buys the shares. The amount of a front-end sales charge is limited by FINRA rules. Such charges cannot exceed 8.5 percent, or a lower limit (down to 6.25 percent) depending on other fees charged by the fund.

Asset-based sales charge: An "asset-based" sales charge is paid over time out of the fund's assets — in other words, out of the fund itself — rather than out of each individual investor's account. Existing rules also limit asset-based sales charges. The current limit on the rate is 0.75 percent per year, but there is no limit on how long a fund can pay these charges if it continues to make significant new sales to investors. As a result, shareholders may pay asset-based charges through the fund for as long as they own the fund.

The proposal would limit the amount of asset-based sales charges that individual investors pay. In particular, the proposal would restrict these "ongoing sales charges" to the highest fee charged by the fund for shares that have no ongoing sales charge. For example, if one class of the fund charges a 4 percent front-end sales charge, another class could not charge more than 4 percent in total to investors over time. The fund would keep track of how long investors have been paying ongoing sales charges.

Separately, funds could continue to pay 0.25 percent per year out of their assets for distribution as "marketing and service" fees, for expenses such as advertising, sales compensation and services.

Improve Transparency of Fees for Investors

Enhance Disclosure Requirements: Currently fund distribution costs are not well understood by investors, in part because these costs are often referred to obscurely as "12b-1 fees." In addition, fund transaction confirmation statements delivered to investors typically do not include sales charges.

The proposal would require the fund to identify and more clearly disclose distribution fees. In particular, the fund would have to disclose any "ongoing sales charges" and any "marketing and service fees" in the fund's prospectus, shareholder reports and investor transaction confirmations. Transaction confirmations also would have to describe the total sales charge rate that an investor will have to pay.

Encourage Retail Price Competition

Allow Funds to Sell Shares Through Broker-Dealers Who Establish Their Own Sales Charges: Currently all broker-dealers who sell shares in a fund must sell those shares under terms established by the fund and disclosed in its prospectus. This means that dealers cannot compete with each other by reducing sales charges.

The proposal would enable funds to sell shares through broker-dealers who determine their own sales compensation, subject to competition in the marketplace. As a result, broker-dealers could establish their own sales charges, tailor them to different levels of shareholder service, and charge shareholders directly, similar to how commissions are charged on securities such as common stock.

The proposal would prevent funds that rely on this exemption from deducting other sales charges from fund assets for that class of shares. This restriction would prevent double-charging.

Revise Fund Director Oversight Duties

Revise Director Duties to Reflect Current Market Practices: Currently, before using fund assets to pay for fund distribution expenses, a fund must adopt a written plan describing the arrangement. The fund's board of directors must initially approve and annually re approve the plan. But the economic realities of long-term distribution arrangements often mean that fund distribution plans are re-approved year after year, with no change.

The proposed amendments, which would set automatic limits on fund fees and charges, would eliminate the need for fund directors to explicitly approve and re-approve fund distribution financing plans. As a result, fund directors would have more time to devote to other important matters.

Directors would still have responsibility for overseeing ongoing sales charges and marketing and service fees in the same manner that they oversee other fund expenses, subject to their general fiduciary duties.

  • The proposal would provide a transition period for the new rules, and also would revise confirmation statement requirements regarding callable debt securities.

There will be a 90-day public comment period after publication of the proposal in the Federal Register.

Mutual funds providing inadequate disclosure on derivatives: SEC

U.S. regulators said mutual funds aren’t telling investors enough about why they use derivatives, with some funds providing “generic” disclosures and others failing to explain how the products affect performance.

Regulators said they are concerned that the use of derivatives has increased in the mutual-fund industry without shareholders comprehending the risks or investment strategies. Some funds offer information that “may not be consistent with the intent” of required registration forms, the Securities and Exchange Commission wrote in a July 30 letter to the Investment Company Institute, the industry’s biggest trade group.

The SEC also raised concerns about “abbreviated” disclosures that give investors a false sense of security about how much funds rely on derivatives.

“While more abbreviated disclosures could lead some investors to believe that a fund’s exposure to derivatives is minimal, we have observed that some funds employing this type of disclosure, in fact, appear to invest significantly in derivatives,” wrote Barry Miller, an associate director in the SEC’s division of investment management.

As a result of the inadequate disclosures, investors may not know which products are used to generate profits, Miller said in the letter. He advised all funds that use derivatives to “assess the accuracy and completeness” of their disclosures.

Washington-based ICI, the mutual-fund industry’s biggest trade group, had no immediate comment.

Derivatives are securities whose value is tied to assets such as stocks, bonds or commodities. Congress last month increased regulation of the products after transactions tied to the U.S. housing market were blamed for triggering the financial crisis and the near-collapse of companies including American International Group Inc.


Regulators have previously said they were particularly focused on leveraged and inverse exchange-traded funds, which rely on swaps to amplify profits or post inverse returns to an index. Such strategies enable funds to get around restrictions on borrowing implemented under the 1940 Investment Company Act.

The SEC announced in March it wouldn’t approve new ETFs that make significant use of derivatives until the agency completed an examination of the practice. While the review is ongoing, the SEC’s Miller said the agency wanted to inform the industry of some of its initial observations.

“We believe these observations may give investment companies immediate guidance to provide investors with more understandable disclosures,” Miller wrote in his letter to Karrie McMillan, the Investment Company Institute’s general counsel.

SEC evaluating the use of derivatives by funds

The SEC staff is conducting a review to evaluate the use of derivatives by mutual funds, exchange-traded funds (ETFs) and other investment companies. The review will examine whether and what additional protections are necessary for those funds under the Investment Company Act of 1940.

Pending the review's completion, the staff has determined to defer consideration of exemptive requests under the Investment Company Act to permit ETFs that would make significant investments in derivatives. The staff's decision will affect new and pending exemptive requests from certain actively-managed and leveraged ETFs that particularly rely on swaps and other derivative instruments to achieve their investment objectives. The deferral does not affect any existing ETFs or other types of fund applications.

"It's appropriate to engage in a more thorough review of the use of derivatives by ETFs and mutual funds given the questions surrounding the risks associated with the derivative instruments underlying many funds," said SEC Chairman Mary Schapiro.

"Although the use of derivatives by funds is not a new phenomenon, we want to be sure our regulatory protections keep up with the increasing complexity of these instruments and how they are used by fund managers," said Andrew Donohue, Director of the SEC's Division of Investment Management. "This is the right time to take a step back and rethink those protections."

The staff generally intends to explore issues related to the use of derivatives by funds, including, among other things, whether:

current market practices involving derivatives are consistent with the leverage, concentration and diversification provisions of the Investment Company Act

funds that rely substantially upon derivatives, particularly those that seek to provide leveraged returns, maintain and implement adequate risk management and other procedures in light of the nature and volume of the fund's derivatives transactions

fund boards of directors are providing appropriate oversight of the use of derivatives by funds

existing rules sufficiently address matters such as the proper procedure for a fund's pricing and liquidity determinations regarding its derivatives holdings

existing prospectus disclosures adequately address the particular risks created by derivatives

funds' derivative activities should be subject to special reporting requirements

The staff also will seek to determine what, if any, changes in Commission rules or guidance may be warranted.

Registered investment companies enable investors to purchase shares in a portfolio of securities. ETFs are similar to traditional mutual funds, and, like those funds, may seek to track an underlying benchmark or securities index or be actively managed. Unlike traditional mutual funds, shares of an ETF can be traded throughout the day on a securities exchange. In addition, "leveraged" ETFs are index-based ETFs that seek to deliver multiples or inverse multiples of the daily performance of the selected index using swaps and other derivatives.


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