FTC Staff Comment Before the SEC Concerning Proposed Regulations Governing the Payment of Asset-Based Sales Loads by Registered Open-End Investment Management Companies

V880053
Comments 	of 	the 	Staff 	of 	the 	Bureau 	of 	Economics
of 	the 	Federal 	Trade 	Commission*
on 	COMMISSION AUTHORIZED
Proposed Regulations 	of 	the
Securities 	and 	Exchange 	Commission
'Governing 	the 	Payment 	of Asset-Based 	Sales 	Loads
by Registered Open-End 	Investment Management 	Companies
File 	No. 	S7-10-88
December 	14, 	1988
Submitted 	in 	triplicate 	to:
Jonathan G. 	Katz, 	Secretary
Securities 	and 	Exchange 	Commission
450 	Fifth Street, 	N.W.
Washington, 	D.C.
* 	These 	comments 	are 	the 	views 	of 	the 	staff 	of 	the 	Bureau
of 	Economics 	of 	the 	Federal 	Trade 	Commission. 	They 	are 	not
necessarily 	the views 	of 	the 	Commission 	or 	any 	individual
Commissioner. 	Please 	contact 	staff 	economist 	Laurence 	Schumann
at 	(202) 	326-3359 	should you 	have 	any questions 	regarding 	our 	comments.

I. 	INTRODUCTION
The SEC 	requests 	comment 	on 	several 	proposed 	amendments 	to
rule 	12b-1 	of 	the 	Investment 	Company Act 	of 	1940 	(hereafter
referred 	to 	as 	the Act).1 	Rule 	12b-l 	permits 	mutual 	funds 	to 	use
fund 	assets 	to 	pay costs 	associated 	with 	the 	distribution 	of 	fund
shares. 2 	The 	proposed 	amendments 	would, 	among 	other 	things,
define 	paYments 	made 	under 	a 	distribution plan 	as 	"asset-based
sales 	loads," 	prohibit 	funds 	that 	adopt 	or 	continue 	distribution
plans 	from 	being held out 	to 	the 	public 	as 	"no-load" 	funds,
clarify 	standards 	for 	approval 	or continuation of 	distribution
plans, 	and 	require 	that 	paYments 	under 	a 	distribution 	plan be
made 	on 	a 	current 	basis 	and 	be 	for 	specific 	distribution 	services
actually provided 	to 	the 	fund. 3
The 	proposed 	amendments 	that 	define 	the 	payments 	made 	under
a 	12b-l 	plan 	as 	an 	"asset-based 	sales 	load" 	and 	prohibit 	funds
that 	have 	adopted 	12b-l 	plans 	from 	promoting 	themselves 	as 	no-
load 	funds 	may 	improve 	investor welfare. 	These 	amendments
recognize 	the 	similarity 	in effect 	and 	purpose 	of 	12b-l
distributions 	plans 	and 	traditional 	sales 	loads 	and 	could 	act 	to
protect 	current 	and 	potential 	mutual 	fund 	shareholders 	from 	being
confused or misled 	by 	funds 	that 	have 	adopted 	12b-1 	plans.
On 	the 	other 	hand, 	the 	proposed 	amendments 	that 	require 	12b-
1
2
15 	U.S.C. 	80a-l 	et 	seg.
17 eFR 	270.12b-1, 	adopted October 	28, 	1980.
3 	Federal 	Register, 	Vol. 	53, 	No. 	119 	(June 	21, 	1988), 	pages
23258-23286. 	Release 	No. 	IC-16431. 	File 	No. 	57-10-88.
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1 payments 	to be made 	on 	a 	current-year basis 	and 	that 	restrict
the 	uses 	of 	12b-l 	fees 	may 	not 	be 	in the 	best 	interests 	of 	mutual
fund 	investors. 	These 	restrictions 	likely will 	substantially
reduce 	the 	feasibility 	of 	12b-l 	distribution 	plans 	as
alternatives 	to 	front-end 	sales 	loads 	and 	limit 	the 	choices
available 	to mutual 	fund 	investors. 	The 	issue, 	then, 	is 	whether
these 	probable negative 	effects 	of 	the 	restrictions 	would 	be
counterbalanced by 	probable 	beneficial 	effects.
II. 	FTC 	STAFF ANALYSIS AND RECOMMENDATIONS
The 	staff 	of 	the 	Bureau 	of 	Economics 	(BE) 	of 	the 	Federal
Trade 	Commission 	submits 	the 	following 	comments 	in 	response 	to
the 	SEC 	request. 	The 	Federal 	Trade 	Commission 	is 	charged 	by
statute with preventing 	unfair methods 	of 	competition 	and 	unfair
or 	deceptive 	practices 	in or 	affecting commerce. 4 	Pursuant 	to
this 	mandate, 	the 	FTC 	has 	provided comments 	to 	federal, 	state,
and 	local 	legislatures 	and 	administrative 	agencies 	on matters
that 	raise 	issues 	of 	competition or 	consumer 	protection policy.
In 	particular, 	the 	staff 	of 	the 	Federal 	Trade 	Commission 	has
recently examined various 	regulations 	affecting competition 	in, 	.
capital 	markets 	and 	investor welfare. 5
4 	15 	U.S.C. 	S45.
5 	Examples 	include Hilke, 	Minimum 	Duality Versus 	Disclosure
Regulations: 	State 	Regulation 	of 	Interstate Opened-End
Investment 	Company 	and 	Common Stock 	Issues 	(Federal 	Trade
Commission, 	1987) 	and 	Schumann, 	State Regulation 	of 	Takeovers 	and
Shareholder Wealth: 	The 	Effects 	of 	New 	York's 	1985 	Takeover
Statutes 	(Federal 	Trade 	Commission, 	1987). 	Over the 	last 	year,
the 	FTC 	staff 	has 	submitted comments 	on proposed 	regulations
2

A. 	Background
Before adoption of 	rule 	12b-l, 	sales 	commissions 	and 	other
distribution costs 	were 	generally 	financed 	through 	front-end
sales 	loads. 	A front-end 	sales 	load 	is 	defined 	as 	the 	difference
between the 	price 	of 	a 	security and 	that 	portion 	of 	the 	proceeds
from 	its 	sale 	that 	is 	invested by 	the 	issuer. 	Typically, 	a
portion of 	a 	front-end 	sales 	load 	is 	used 	to 	pay 	sales
commissions 	to 	brokers 	and 	the 	remainder 	is 	used 	by 	the 	fund's
distributor 	(typically, 	an 	affiliate 	of 	the 	fund's 	management
company) 	to 	pay 	processing 	or other distribution 	costs. 	Under
the 	authority granted by 	section 	22(b) 	of 	the 	Act, 	the 	National
Association of 	Securities 	Dealers 	(NASD) 	rules 	specify that 	sales
charges 	may 	be 	no 	greater 	than 	8.5% 	of 	the 	offering 	price. 6
Rule 	12b-l 	permits, 	subject 	to 	specified conditions, 	a
mutual 	fund 	to 	adopt 	a 	plan to 	use 	a 	portion of 	fund 	assets 	to
finance 	activities 	primarily 	intended 	to 	result 	in 	the 	sale 	of
fund 	shares. 	Unlike 	a 	front-end 	load 	fee 	that 	is 	paid 	at 	the
time 	of 	purchase, 	12b-l 	plans 	charge 	an 	annual 	fee 	and 	typically
specify 	a 	maximum 	annual 	payment 	as 	a 	percentage 	of 	net 	asset
affecting 	investors 	to 	the 	Securities 	and 	Exchange 	Commission 	and
the 	Delaware, 	New 	Jersey, 	New York, 	and 	Texas 	state 	legislatures.
6 	Some 	funds 	charge 	-back-end" 	sales 	loads 	that 	are
assessed when 	fund 	shares 	are 	redeemed. 	The 	8.5% 	limit 	on 	sales
charges 	set 	by 	the 	NASD 	applies 	to 	the 	sum of 	all 	charges 	levied
whether 	through 	front-end 	loads, 	back-end 	loads, 	or a 	combination
of 	both; 	however, 	the 	limit 	does 	not 	apply 	to 	l2b-l 	payments.
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value. 7 	Different 	plans 	have 	maximum 	12b-1 	fees 	ranging 	from
less 	than 	0.25% 	of 	a 	fund's 	net 	asset 	value 	(NAV) 	to 	1.25% 	of
NAV.8 	12b-1 	plans 	are 	generally used 	alone 	or 	in conjunction
with 	a 	contingent 	deferred 	sales 	load 	(CDSL)9 	as 	a 	substitute 	for
a 	front-end 	load 	fee: 	however, 	some 	funds 	have 	adopted 	12b-l
plans 	to 	supplement 	front-end 	loads.
The 	proposed 	amendments 	to 	12b-l 	address 	certain practices
that 	have 	developed 	under 	the 	existing 	rule. 	As 	noted 	in 	the 	SEC
proposal, 	the 	innovative use 	of 	rule 	12b-l 	has 	resulted 	in 	a 	wide
variety of 	distribution 	arrangements 	and 	practices 	that 	were 	not
anticipated 	at 	the 	time 	that 	the 	rule was 	adopted. 	Practices
that 	are 	of 	particular concern 	to 	the 	SEC 	include 	1) 	the 	use 	of
the 	label 	"no-load" 	by 	funds 	that 	have 	adopted 	12b-l 	plans, 	2)
"reimbursement 	plans" 	that 	allow 	annual 	distribution 	spending 	to
exceed 	annual 	payments 	by 	the 	fund, 	and 	3) 	"compensation plans"
7 	Under 	Rule 	12b-l, 	a 	plan may 	continue 	for 	more 	than 	one
year 	only 	if 	it 	is 	approved 	annually 	by a 	majority of 	the 	fund's
board 	of 	directors 	and 	of 	the 	disinterested 	directors. 	Thus,
strictly speaking, 	a 	12b-1 	plan applies 	for 	a 	single 	year 	and 	is
not 	a 	recurring 	annual 	charge.
8 	J. 	A. 	Haslen, 	The 	Investor's 	Guide 	to 	Mutual 	Funds,
Englewood 	Cliffs, 	N.J.: 	Prentice-Hall, 	Inc., 	1988, 	at 	57.
9 	A CDSL 	is 	a 	type 	of 	sales 	load paid, 	if 	at 	all, 	at 	the
time 	shares 	are 	redeemed. 	A CDSL 	typically 	starts 	at 	5 	or 	6% 	of
the 	original 	purchase 	price 	of 	the 	shares 	redeemed 	and 	declines
by 	1% 	for 	each year 	the 	shares 	are 	held 	by 	the 	investor. 	Thus,
if 	a 	fund 	charges 	a 	6% 	CDSL 	and 	an 	investor 	redeems 	his 	shares
within 	one 	year 	of 	their purchase, 	he 	pays 	a 	6% 	sales 	load, 	if 	he
redeems 	his 	shares 	within 	two 	years, 	he 	pays 	a 	5% 	sales 	load, 	and
so 	on. 	Unlike 	12b-l 	payments, 	CDSLs 	are 	subject 	to 	NASD 	sales
load 	regulations. 	They 	are 	generally used 	in 	conjunction with
12b-l 	plans 	to 	insure 	that 	investors 	redeeming 	shares 	fully 	repay
any 	deferred 	distribution 	costs.
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in which 	payments 	made 	by 	the 	fund 	are 	not 	tied 	to 	the 	level 	of
distribution 	spending.
B. 	Labelling 	and 	Disclosure 	of 	12b-1 	Fees
As 	discussed 	above 	and 	in various 	sections 	of 	the 	SEC
proposal, 	12b-1 	fees 	are 	typically 	used 	to 	pay 	sales 	commissions
and 	other types 	of 	distribution costs 	traditionally covered by
sales 	loads. 	Whereas 	front-end 	sales 	loads 	are 	charged 	at 	the
time mutual 	fund 	shares 	are 	initially purchased 	and 	applied 	to
distribution 	costs 	at 	the 	time 	of 	sale, 	fees 	assessed 	under 	12b-1
plans 	enable 	shareholders 	to 	spread 	the 	payments 	for
distribution 	services 	over 	time. 	The 	proposed 	amendment 	to 	12b-1
designating 	12b-1 	charges 	as 	"asset-based 	sales 	loads" 	recognizes
that 	12b-1 	plans 	serve 	essentially 	the 	same 	purpose 	as
traditional 	front-end 	loads, 	and 	should be 	thought 	of 	as 	a 	form
of 	load 	fee 	spread 	over 	time 	rather 	than 	paid 	at 	the 	time 	of
purchase.
From the 	time 	that 	the Act was 	passed by Congress 	in 	1940 	to
the 	time 	that 	rule 	12b-1 was 	adopted 	in 	1980, 	the 	terms 	"load
fund" 	and 	"no-load 	fund" 	co~veyed to 	mutual 	fund 	investors
precise 	characteristics 	of 	the 	particular 	types 	of 	funds. 	Load
funds 	were 	typically 	sold by brokers 	who 	received 	commissions
from 	fees 	(sales 	loads) 	charged 	investors 	at 	the 	time 	of 	sale;
no-load 	funds 	were 	typically 	sold 	directly 	to 	investors, 	with 	the
funds' 	underwriters 	abs~rbing any 	costs 	arising 	from 	the 	sale 	and
distribution 	of 	the 	funds' 	shares. 	With 	the 	adoption 	of 	rule
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12b-1, 	mutual 	funds 	that 	did 	not 	charge 	traditional 	load 	fees
have 	been able 	to 	finance 	brokers' 	commissions 	and 	other
distribution costs 	through 	12b-1 	distribution 	plans. 	While 	12b-1
plans 	serve 	the 	same 	pUrPOse 	as 	sales 	loads, 	rule 	12b-1 	does 	not
currently define 	or 	refer 	to 	such 	plans 	as 	"asset-based 	sales
loads." 	Consequently, 	some 	funds 	that 	have 	adopted 	12b-1 	plans
advertise 	or 	otherwise 	promote 	themselves 	as 	no-load 	funds.
Since mutual 	fund 	investors 	have 	for 	many years 	believed 	that 	the
term 	"no-load" 	refers 	to 	funds 	that 	do 	not 	charge 	investors 	fees
to 	cover 	brokers' 	commissions 	or 	other distribution 	costs, 	some
investors 	may 	be confused 	or misled 	by 	funds 	with 	12b-1 	plans
that 	hold 	themselves 	out 	to 	the 	public 	as 	no-load 	funds. IO 	The
designation 	of 	12b-1 	fees 	as 	"asset-based 	sales 	loads" 	can,
therefore, 	be viewed 	as 	a 	disclosure 	to 	current 	or 	potential
mutual 	fund 	investors 	of 	the 	true 	purpose 	and 	role 	of 	12b-1 	fees.
When 	viewed 	in 	this 	light, 	characterizing 	12b-1 	funds 	as 	"no-
load" 	funds 	differs 	little 	from 	characterizing 	funds 	charging
front-end 	sales 	loads 	as 	"no-load" 	funds. 	Thus, 	the 	adoption 	of
amendments 	that 	would 	(1) 	designate 	12b-1 	plans 	as 	"asset-based
sales 	loads" 	and 	(2) 	prohibit 	funds 	that 	adopt 	12b-1 	plans 	from
promoting 	themselves 	as 	no-load 	funds, 	could 	act 	to 	prevent
potentially misleading 	and 	deceptive 	claims 	by mutual 	funds.
10 	According 	to 	footnote 	197 	in 	the 	SEC 	proposal, 	the 	SEC
has 	received 	hundreds 	of 	letters 	from 	individual 	investors
complaining 	of 	the 	"hidden 	loads" 	created by 	12b-1 	plans. 	Many
of 	these 	investors 	claim 	to 	have 	been misled 	by 	sales 	literature
or 	salesmen 	into 	thinking 	that 	a 	particular 	fund 	did 	not 	charge
for 	distribution, 	when 	in 	fact 	it 	assessed 	12b-1 	fees.
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c. 	Amendments 	Affecting 	"Reimbursement" 	Plans
A "reimbursement 	plan" 	is 	a 	common 	type 	of 	12b-l 	plan 	that
is 	a 	major 	concern 	to 	the 	SEC. 	Under 	this 	type 	of 	plan, 	a 	fund's
distributor 	advances 	on 	the 	fund's 	behalf 	the 	cost 	of 	brokers'
commissions 	and 	other 	distribution expenses 	associated with 	the
sale 	of 	fund 	shares. 	The 	distributor 	is 	later reimbursed 	through
12b-l 	fees. 	When 	distribution 	costs 	incurred 	in 	any 	given year
exceed 	the 	maximum 	annual 	fees 	allowed 	by 	the 	plan, 	the 	excess
distribution costs 	are 	typically 	"carried 	forward" 	in
anticipation of 	repayment 	under 	the 	plan 	in 	future 	years.
The 	SEC 	is 	concerned with 	the 	magnitude 	of 	distribution
spending carried 	forward 	from 	prior years, 	and 	the 	possibility
that 	some 	investors 	who 	leave 	a 	12b-l 	fund 	do 	not 	pay 	their 	pro
rata 	share 	of 	the 	distribution expenditures. 	Further, 	since 	the
level 	of 	actual 	distribution 	spending 	is 	often 	determined 	by 	fund
distributors 	under 	a 	reimbursement 	plan, 	the 	SEC 	believes 	that
the 	review 	of 	annual 	distribution 	expenditures 	by 	fund 	directors
may 	not 	adequately 	protect 	shareholders.
To 	address 	these 	concerns, 	the 	SEC 	proposes 	rule 	12b-
l(c)(l)(ii). 	This 	rule 	restricts 	the 	ability 	of 	a 	fund 	to 	pay
for 	distribution 	expenses 	incurred 	on 	the 	fund's 	behalf 	in 	prior
years, 	thereby 	insuring 	that 	distribution 	services 	financed 	under
12b-l 	plans 	are 	paid 	for 	on 	a 	current 	basis. 	Rule 	12b-
l(c)(l)(ii) 	essentially prohibits 	reimbursement 	plans.
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Before adopting 	such 	a 	restrictive 	rule, 	however, 	the 	SEC
might want 	to 	consider 	the 	extent 	of 	the 	problem,ll 	the 	potential
costs 	of 	the 	rule, 	and 	solutions 	that 	might 	already be 	in 	use 	or
might 	be 	adopted 	at 	less 	cost 	to 	investors. 	Adoption 	of 	rule
12b-l(c)(I)(ii): 	(1) 	limits 	the 	choices 	available 	to 	mutual 	fund
investors 	by denying 	them 	an 	opportunity 	to 	pay distribution
costs 	over 	time 	rather 	than 	up 	front;12 	and 	(2) 	may 	potentially
reduce 	competition among mutual 	funds 	by deterring entry of 	new
funds. 13
As 	noted 	above, 	12b-l 	plans 	typically charge 	annual 	fees 	as
a 	percentage 	of 	the 	fund's 	net 	asset 	value; 	consequently,
distribution 	costs 	borne 	by 	a 	new 	fund's 	distributor 	typically
11 	The 	SEC 	proposal provides 	anecdotal 	evidence 	of 	large
unreimbursed 	expenditures, 	but 	does 	not 	provide 	any 	systematic
evidence 	of 	how widespread 	the 	problem 	actually 	is.
12 	The 	SEC 	has 	recently 	recognized 	the 	potential 	benefits 	to
mutual 	funds 	and 	investors 	of 	spreading distribution 	paYments 	over
time 	by 	proposing 	rule 	6c-l0 	(Federal 	Register, 	Vol. 	53, 	No. 	217
(November 	9, 	1988), 	pages 	45275-45285). 	This 	rule, 	if 	adopted,
would 	allow, 	among 	other 	things, 	for 	deferred 	paYments 	of
traditional 	(i.e., 	not 	"asset-based") 	sales 	loads. 	Under 	this 	rule, 	tl
paYment 	of 	distribution charges 	over time 	would 	no 	longer 	be 	a
unique 	characteristic 	of 	12b-l 	plans; 	nevertheless, 	even 	if 	this 	rule
is 	eventually adopted, 	it 	is 	far 	from 	clear 	that 	eliminating 	the
"spread-load" 	characteristics 	of 	12b-l 	plans.would be 	beneficial 	or
even 	necessary. 	If 	investors 	prefer mutual 	funds 	with 	6c-l0 	fee
structures 	over 	12b-l 	funds, 	competition among 	funds 	would 	force
the 	eventual 	demise 	of 	12b-l 	plans.
13 	Currently, 	a 	large 	number of 	mutual 	funds 	exist 	and
competition 	among 	them can be 	fierce; 	consequently, 	limits 	on 	new
entry 	in 	the 	industry would 	not, 	in 	itself, 	necessarily 	reduce
competition. 	Nevertheless, 	entry 	into 	the 	industry by 	new 	funds 	is
a 	highly 	important method 	by which 	diversified portfolios
containing new and 	innovative 	financial 	products 	become 	available
to 	small 	investors. 	Thus, 	regulations 	that 	act 	to 	restrict 	entry 	in
the 	industry may 	potentially 	lessen 	competition by 	preventing 	an
important means 	by which 	innovation enters 	the 	industry.
8

exceed 	the 	maximum payments 	allowed 	under 	the 	12b-l 	plan.
Currently, 	distributors 	of 	new 	funds 	willingly bear these 	start-
up 	costs 	since 	they can be 	reimbursed 	through 	12b-l 	fees 	assessed
in 	later years. 	The 	SEC 	proposal 	requiring 	that 	payments 	under
the 	distribution 	plan be made 	on 	a 	current year basis 	prevents
distributors 	from 	spreading 	the 	start-up 	costs 	over 	time. 	The
proposal 	suggests 	that 	one 	alternative 	available 	to 	funds 	is 	to
raise 	the 	maximum 	amounts 	payable 	under 	the 	12b-1plan; 	however,
if 	distribution costs 	are 	of 	similar magnitude 	for 	funds 	that
charge 	12b-1 	fees 	as 	they 	are 	for 	funds 	that 	charge 	sales 	loads,
then 	the 	requirement 	that 	payments 	be made 	on 	a 	current 	year
basis 	necessitates 	that 	12b-1 	fees 	be 	of 	a 	magnitude 	similar 	to
an 	alternative 	sales 	load. 	Any benefits 	that 	investors 	may
receive 	from 	spreading 	distribution costs 	over 	time 	would 	be
lost. 	Moreover, 	since management 	companies 	no 	longer would 	be
permitted 	to 	defer 	reimbursement 	to 	later years, 	and 	since 	funds
typically 	have 	high 	start-up costs, 	the 	proposed 	rule 	may
discourage 	the 	entry of 	new 	12b-1 	funds.
Under 	SEC 	regulations 	that 	became 	effective May 	1, 	1988,14
mutual 	funds 	must 	disclose 	in 	their 	annual 	prospectuses 	the 	level
of 	12b-1fees 	as 	a 	percentage 	of 	average 	net 	assets 	and 	the
amount 	of 	any 	unreimbursed 	distribution 	spending 	incurred 	in
previous 	years 	under 	12b-l 	plans. 	Such disclosures 	should 	act 	to
minimize 	potential 	harm 	to 	investors 	that 	could 	result 	from 	high
14 	See 	"Consolidated Disclosure 	of Mutual 	Fund 	Expenses," 	S3
FR 	3192, 	February 	4, 	1988.
9

levels 	of 	unreimbursed 	spending. 	If 	investors 	view 	high 	levels
of 	unreimbursed 	spending 	as 	potentially 	harmful, 	or 	if 	high
levels 	of 	unreimbursed 	spending 	induce 	directors 	to 	continue
plans 	that 	are 	not 	in 	the 	best 	interest 	of 	the 	funds 	or 	their
shareholders, 	then 	shareholders 	can choose 	to 	invest 	their
savings 	in different 	mutual 	funds. 	Thus, 	competition among 	funds
should 	act 	to 	keep 	unreimbursed 	distribution 	spending 	from
reaching 	levels 	viewed 	as 	potentially harmful 	by mutual 	fund
investors.
The 	disclosures 	should encourage 	funds 	with 	l2b-l 	plans 	to
initiate 	solutions 	to 	these 	problems. 	For example, 	many 	funds
with 	12b-l 	plans 	have 	already 	adopted CDSLs 	to 	avoid 	the 	problem
of 	shareholders 	redeeming 	their 	shares 	before 	having 	fully 	repaid
the 	expenditures 	incurred 	to 	sell 	them. 	Alternatively, 	if 	funds
attempt 	to 	levy excessive 	l2b-l 	fees 	on current 	shareholders 	to
pay 	the 	distribution costs 	incurred on behalf 	of 	former
shareholders, 	the 	shareholders 	will 	"vote with 	their 	feet" 	and
invest 	their 	funds 	in 	other mutual 	funds. 	However, 	we 	would
expect 	competition among 	funds 	for 	investment 	capital 	to 	force
funds 	to 	find 	solutions. 	Thus, 	the 	required 	disclosure 	of 	the
levels 	of 	l2b-l 	fees 	and 	unreimbursed 	spending, 	in 	combination
with 	the 	high 	level 	of 	competition among mutual 	funds, 	may
protect 	the 	interests 	of 	mutual 	fund 	investors 	without 	the 	need
for 	effectively prohibiting reimbursement 	plans. 	It 	is 	possible
that 	there 	was 	not 	enough 	time 	to 	determine 	the 	effectiveness 	of
the 	new 	disclosure 	rules 	by 	the 	date 	of 	the 	SEC's 	proposal. 	We
10

recommend 	that 	the 	SEC 	determine 	to what 	extent 	the 	new
disclosure 	rules 	and 	actions 	taken 	by 	the 	funds 	themselves 	(such
as 	the 	adoption of 	CDSLs) 	may 	alleviate 	perceived problems, 	and
how much of 	a 	problem remains. 1S
Even 	if 	the 	SEC 	rejects 	the 	notion 	that 	the 	combination of
disclosure 	and 	competition can 	act 	to 	protect 	the 	interests 	of
mutual 	fund 	shareholders, 	the 	SEC 	could 	consider 	substantially
less 	restrictive means 	than 	the 	effective 	prohibition of 	such
plans. 	In conjunction with 	amendment 	12b-l(c)(1)(ii), 	the 	SEC
proposes 	amendment 	12b-l(b)(S) 	that 	is 	designed 	to 	eliminate,
within 	a 	reasonable 	time, 	unreimbursed 	distribution 	spending
existing 	at 	the 	time 	rule 	12b-l(c)(1)(ii) 	becomes 	effective. 	One
less 	restrictive 	alternative 	to 	12b-l(c)(1)(ii) 	is 	to 	adopt 	a
modified 	amendment 	12b-l(b)(S). 	The amendment 	might 	require
directors 	to 	take 	actions 	to 	reduce 	the 	level 	of 	unreimbursed
excess 	distribution 	spending whenever 	the 	amounts 	carried 	forward
become 	sufficiently 	large. 	The 	levels 	of 	unreimbursed
expenditures 	that 	would 	invoke 	such 	action could be 	specified 	in
the 	rule 	as 	a 	percentage 	of 	net 	assets. 	Excessive 	unreimbursed
expenditures 	carried forward 	could be 	reduced 	over 	time 	and 	the
problems 	associated with 	them 	avoided. 	Requiring 	that 	12b-l
plans 	include 	such 	provisions 	could 	satisfy the 	SEC's 	concerns
15 	Some 	problems 	may 	remain because 	shareholders 	cannot
conduct 	transactions 	costlessly and 	do 	not 	receive 	information
instantaneously. 	The 	recently 	proposed 	rule 	6c-l0 	(see 	footnote
11), 	if 	adopted, 	would 	greatly 	facilitate 	the 	adoption of 	CDSLs 	by
eliminating 	the 	need 	for 	funds 	to 	obtain 	individual 	exemptive orders
prior 	to 	charging CDSLs.
11

with excessive unreimbursed expenditures 	without 	denying
investors 	the 	choice 	of 	paying 	for 	distribution expenditures 	over
time 	through 	reimbursement 	plans.
D. 	Amendments 	Restricting 	the 	Use 	of 	"Compensation" 	Plans
A second 	type 	of 	12b-l 	plan 	that 	concerns 	the 	SEC 	is 	a
"compensation" 	plan. 	Under 	this 	type 	of 	plan, 	the 	annual 	level
of 	payments 	is 	fixed 	i? 	advance, 	typically 	as 	a 	percentage 	of 	the
fund's 	net 	assets, 	and 	is 	not 	necessarily 	related 	to 	the 	level 	of
distribution 	services 	provided by 	the 	recipient 	of 	the 	fees,
generally 	the 	fund's 	principal 	underwriter. 	While 	the 	value 	of
distribution 	services 	received by 	the 	fund 	could exceed 	the
amount 	paid under 	the 	plan, 	such 	an 	arrangement 	could 	possibly
result 	in 	the 	fund 	paying more 	than 	reasonable 	compensation 	for
the 	services 	actually 	provided. 	In 	the 	extreme, 	the 	fund 	could
pay 	its 	distributor 	12b-l 	fees 	and 	receive 	no 	services 	at 	all 	in
return.
To 	address 	these 	concerns, 	the 	SEC 	is 	proposing 	a 	number 	of
amendments 	to 	rule 	12b-l 	that 	would 	effectively prohibit
compensation plans. 	Rule 	12b-l(b)(9) 	requires 	that 	amounts
accrued 	under 	a 	fund's 	12b-l 	plan 	reasonably 	correlate 	each
quarter with 	the 	fund's 	distributional 	expenses. 	Rule 	12b-
1(c)(1)(i) 	prohibits 	the 	use 	of 	fees 	assessed 	under 	a 	12b-l 	plan
for 	nondistributional 	expenses 	by 	limiting 	their use 	to
reimbursement 	for 	specific 	sales 	or 	promotional 	services
identified 	in 	the 	plan.
12

Before adopting 	these 	reforms, 	the 	SEC 	should 	reconsider
whether 	these 	restrictions 	on 	the 	use 	of 	l2b-l 	fees 	are
necessary. 	The 	restrictions 	intended 	to 	limit 	the 	use 	of
compensation plans 	may 	act 	to 	induce 	funds 	to 	use 	traditional
sales 	loads 	rather 	than 	12b-1 	plans. 	As 	a 	consequence, 	investors
that 	prefer 	spreading 	load payments 	over 	time may be 	denied 	this
alternative. 	The 	success 	of 	funds 	assessing 	12b-1 	fees 	reflects
the 	desirability of 	this 	type 	of 	sales 	load 	to 	investors.
12b-1 	fees 	serve 	essentially 	the 	same purpose 	as 	sales
loads. 	These 	fees 	are, 	as 	recognized 	by the 	SEC, 	an 	"asset-based
sales 	load." 	In 	practice, 	12b-1 	payments 	constitute 	a 	sales 	load
that 	is 	spread over 	time 	rather 	than paid entirely 	at 	the 	time 	of
share 	purchase 	or redemption. 	With 	a 	traditional 	front-end 	sales
load, 	typically, 	fund 	distributors 	and brokers 	split 	the 	load
fee; 	a 	portion of 	the 	sales 	load 	is 	paid to 	the 	broker 	as 	a
commission 	and 	the 	remainder 	is 	paid to 	the 	distributor. 	The
portion of 	the 	sales 	load 	that 	reverts 	back 	to 	the 	distributor
may be 	used 	to 	pay 	for 	distribution 	services, 	but 	the 	distributor
is 	not 	required 	to 	apply 	all 	(or 	any) 	of 	these 	fees 	to 	actual
distribution 	services, 	unlike 	12b-1 	fees 	under 	the 	proposed
amendments. 	Here, 	the 	SEC 	is 	proposing 	that 	restrictions 	be
placed on 	the 	use 	of 	one 	type 	of 	sales 	load, 	an 	asset-based 	sales
load, 	that 	are 	not 	imposed on 	an 	alternative 	front-end 	sales
load. 16 	Such restrictions 	will 	discourage 	the 	use 	of
16 	That management 	companies 	might view 	front-end 	sales
loads 	and 	12b-1 	fees 	as 	substitutes 	for 	one 	another 	is 	strongly
supported by 	a 	recent 	article 	that 	appeared 	in 	The 	Wall 	Street
13

12b-1 	plans, 	which will 	harm 	those 	mutual 	fund 	investors 	who
would 	prefer 	to 	pay 	sales 	loads 	over time 	rather 	than up 	front. 17
The 	rules 	governing 	12b-1 	plans 	already 	provide 	several
safeguards 	for 	investors. 	The 	SEC 	does 	not 	cite 	evidence 	that
these 	existing 	safeguards 	are 	inadequate, 	and 	therefore 	might
want 	to 	consider 	further 	investigation 	of 	current market
conditions. 	One 	safeguard 	is 	that 	rule 	12b-1, 	as 	adopted 	in
OCtober 	1980, 	relies 	heavily on 	the 	fund's 	directors,
particularly 	the 	disinterested 	directors, 	to 	protect 	the
interests 	of 	the 	fund 	and 	its 	shareholders. 	Whether 	or 	not 	fund
distributors 	earn 	"profit" 	on 	12b-1 	fees 	in 	any 	given year 	or
quarter 	is 	of 	no more 	concern 	than 	whether or 	not 	distributors
earn profits 	from 	traditional 	sales 	loads, 	as 	long 	as 	the
directors 	fulfill 	their 	fiduciary 	duties 	and 	insure 	that 	12b-1
plans 	are 	structured 	in 	the 	interest 	of 	the 	fund 	and 	its
shareholders. 	Further, 	fund 	directors 	have 	the 	authority 	to 	deal
with 	potential 	abuses 	by 	fund 	distributors.
Journal 	Friday, 	September 	9, 	1988 	(p. 	23). 	In 	this 	article, 	The
Wall 	Street 	Journal 	described 	a 	new mutual 	fund 	pricing 	plan 	to
be 	introduced by Merrill 	Lynch 	& Co. 	that 	would 	allow mutual 	fund
shareholders 	the 	option of 	either paying 	an 	initial 	sales 	charge
or 	paying 	annual 	marketing 	and 	distribution 	fees. 	Merrill 	Lynch
is 	offering 	such 	a 	pricing plan presumably because 	some 	investors
prefer 	(and 	are, 	therefore, 	better 	off 	by) 	paying distribution
charges 	over 	time, 	while 	other 	investors 	prefer 	to 	pay
distribution 	charges 	all 	at 	once.
17 	Alternatively, 	if 	the 	existing 	12b-1 	safeguards 	are
inadequate, 	it may well 	be 	that 	similar problems 	are 	manifested 	for
front-end 	sales 	load 	funds. 	In 	such 	a 	case, 	the 	interests 	of
efficiency and 	sYmmetry may 	lead 	to 	the 	conclusion that 	the 	same
restrictions 	now 	proposed 	for 	12b-1 	funds 	be 	applied 	as 	well 	to
front-end 	sales 	load 	funds.
14

Second, 	disclosure 	requirements 	already established 	by 	the
SEC 	protect 	shareholders 	from 	excessive 	or 	unnecessary 	fees.
Annual 	rates-of-return 	reported 	to 	current 	and potential
shareholders 	in 	a 	fund's 	prospectus 	must 	be 	calculated 	net 	of 	all
fees, 	including those 	assessed 	through 	12b-1 	plans. 	As 	discussed
above, 	under 	current 	SEC 	rules, 	a 	fund's 	prospectus 	must 	list 	in
its 	fee 	table 	the 	level 	of 	12b-1 	fees 	as 	a 	percentage 	of 	the
fund's 	net 	asset 	value. 	Furthermore, 	a 	number of 	popular
business 	and 	financial 	magazines 	and 	newsletters 	periodically
publish detailed 	comparisons 	of mutual 	funds' 	returns 	and 	fees. 18
Distributors 	that 	attempt 	to 	earn excessive 	profits 	through 	12b-1
plans 	by 	receiving payments 	that 	do 	not 	correspond 	to 	services
provided shareholders 	will 	find 	that 	the 	funds 	that 	they
distribute 	do 	not 	provide 	competitive 	returns 	to 	shareholders.
As 	long 	as 	shareholders 	can 	"vote with 	their 	feet," 	competition
among 	the 	large 	number 	of 	funds 	available 	will 	further 	protect
the 	interests 	of 	fund 	investors.
III. 	SUMMARY
The 	SEC proposes 	a 	number of 	amendments 	to 	rule 	12b-1
designed 	to 	address 	certain practices 	that 	have 	developed 	under
the 	rule. 	The 	SEC 	proposals 	to 	designate 	12b-1 	fees 	as 	"asset-
18 	Appendix A of 	"Comments 	of 	the 	Bureaus 	of 	Competition,
Consumer Protection, 	and 	Economics 	of 	the 	Federal 	Trade
Commission on Proposed Regulations 	of 	the 	U. 	S. 	Securities 	and
Exchange Commission Governing Performance 	Claims 	and 	in
Advertising 	by 	Investment 	Companies" 	(December 	22, 	1986) 	provides
a 	list 	of 	eight magazines 	and 	seventeen 	newsletters 	that 	regularly
compare mutual 	fund 	performance.
15

based 	sales 	loads" 	and prohibit mutual 	funds 	that 	have 	adopted
12b-1 	plans 	from 	promoting 	themselves 	as 	"no-load" 	funds 	should
promote 	competition 	among mutual 	funds 	and 	benefit mutual 	fund
investors 	by 	improving 	investors' 	understanding of 	the 	nature 	and
purpose 	of 	l2b-1 	plans.
On 	the 	other hand, 	the 	proposed 	amendments 	that 	would
prohibit 	excess 	distribution expenditures 	from 	being carried
forward 	and 	restrict 	the 	uses 	of 	l2b-1 	paYments 	by 	fund
distributors 	may 	harm 	investors. 	l2b-1 	fees 	are 	a 	tyPe 	of 	sales
load, 	an 	"asset-based 	sales 	load," 	that 	provide mutual 	fund
investors 	with 	a 	valued and 	beneficial 	alternative 	to 	traditional
sales 	loads 	to 	finance 	distribution costs. 	The 	prohibition on
excess 	distribution 	spending 	could 	severely 	limit 	the 	ability 	of
new 	funds 	to 	offer 	investors 	the 	choice 	of 	spreading 	load
paYments 	over 	time 	through 	l2b-l 	plans. 	Moreover, 	less
restrictive 	alternatives 	to 	an 	effective 	ban on 	reimbursement
plans 	are 	available. 	The 	proposed 	restrictions 	on 	the 	use 	of
l2b-l 	paYments 	would 	impose 	limitations 	on distributors 	of 	funds
with 	12b-1 	plans 	that 	are 	not 	imposed on distributors 	of 	funds
with 	traditional 	sales 	loads. 	These 	amendments 	will 	likely
lessen 	the 	willingness 	of 	fund 	distributors 	to 	use 	12b-1 	fees 	as
an 	alternative 	to 	traditional 	sales 	loads, 	and, 	consequently,
limit 	the 	choices 	available 	to 	them. 	It 	is, 	of 	course, 	for 	the
SEC 	to 	decide 	whether 	these 	potential 	costs 	of 	the 	adoption 	of
the 	restrictions 	cited above 	are 	outweighed by 	the 	potential
benefits 	to 	investors 	in terms 	of 	certainty and 	security.
16