SEC fact sheet: Improved regulation of fund distribution fees and better disclosure for investors

The following is a fact sheet on proposed changes to 12(b)-1 fees issued by the SEC earlier today.

Overview

The Securities and Exchange Commission today will consider proposing 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.

Background

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% 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 shares 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.