12B-1 Fees: Seriously, Why Are We Still Paying These?

• Author: Sundeep R. Patel, Esq.
• Pages: 11

Sundeep Patel is a business litigation associate with Cooley Godward Kronish LLP. Mr. Patel received his J.D. manga cum laude from American University Washington College of Law.
Even the best-laid plans often go wrong. Rule 12b-1 of the Investment Company Act of 1940 (the "1940 Act") is an example of how well-planned legislation can turn out to be a real-life nightmare. This article is written as a persuasive argument for the Securities and Exchange Commission ("SEC") to amend Rule 12b-1 and to better educate prospective and current investors about 12b-1 fees. Part I of this article provides the historical development of Rule 12b-1 and Part II provides analysis and recommendations for the Rule.
@Historical Overview
Section 12(b) of the 1940 Act prohibits a mutual fund from acting as a distributor of its securities in contravention of any SEC rules. Historically, the SEC interpreted the statutory language of Section 12(b) to mean mutual funds cannot finance, directly or indirectly, the distribution of their shares.1 Because of the SEC's position, prior to the enactment of Rule 12b-1, mutual funds sold through investment advisers and other sales professionals compensated these people for providing shareholders with ongoing investment advice through "front-end" sales loads.2
In 1979, the SEC proposed the adoption of Rule 12b-1. The SEC stated in the accompanying release that "[t]he Commission is taking these actions because it believes that directors and shareholders of open-end management investment companies should be able to make business judgments to use their assets for distribution in appropriate cases...."3
In 1980, the SEC adopted Rule 12b-1, which permits funds to pay distribution-related costs.4 The Rule prohibits an open- end fund from using its own assets to pay for distribution-related costs - such as marketing and advertising - without a written plan adopted by the fund's board and shareholders. When the SEC first adopted the Rule, it thought that 12b-1 plans would solve particular distribution problems such as advertising.5 The Rule is silent, however, on the types of distribution activities that the fund can finance. In fact, the SEC specifically noted that Rule 12b-1 does not restrict the kinds of payments a fund may make; rather, discretion lies with fund boards regarding the fund's distribution-related activities.6
Initially, funds used 12b-1 fees to pay advertising and marketing distribution fees. Since the late 1980s, however, the vast majority of funds have used these fees as a way to "give shareholders the option to pay for services they receive from sales professionals over time rather than a single up front...