Rule 12b-1 in practice.

• Author: Freeman, John P.
• Position: The Mutual Fund Distribution Expense Mess

1. The Early Days

   Immediately following Rule 12b-1's promulgation, the rule was used infrequently. (102) 12b-1 fees were low, typically 0.25% or less, and payments were commonly used to pay such distribution expenses as advertising costs or sales literature mailings. (103) These results were "consistent with the SEC's expectations in adopting the rule." (104) Then the pace of adoption began to pick up and the landscape changed radically. By 1986, the number of funds featuring 12b-1 plans had ballooned to nearly 600, and average fees had risen from "a token" 0.25% to, in some cases, more than 1% annually. (105) During 1987, 390 more funds adopted 12b-1 plans, triple the number of adoptions three years earlier. (106) What began life as a measure calculated to address specific problems facing individual funds, (107) evolved from a targeted, limited response into a large, enduring, and controversial expense fixture within the industry. (108)

2. Rule 12b-1 Nourishes a Potent Marketing Tool--CDSCs and Fund Classes Arise

   When Rule 12b-1 was adopted in October of 1980, fund investors seeking to buy shares had two options. They could buy shares of a load fund through broker-dealers or other professionals, paying a "front-end" sales charge of up to 8.5%, or they could buy shares in a no-load fund offered primarily through advertisements. (109) After the rule's adoption, radical change transformed the fund industry's marketplace. Load fund sales began to zoom.

   Spurring adoption of Rule 12b-1 plans during its early years was a development not anticipated by either the SEC or the industry (110) when the rule was adopted: use of 12b-1 fees in connection with fund classes featuring so-called "contingent deferred sales charges," often called "CDSCs" or "CDSLs," (111) used to market load funds. (112) In contrast with pre-12b-1 days, load funds now routinely offer different classes or series of shares with different attributes. The Class B shares depicted in Table 1 below differ from other classes of shares typically offered by the same load funds. Class A shares, for example, typically bear a front-end load with various "break-points," (113) with or without an ongoing 12b-1 fee. (114) As reflected in Table 1, Class B shares may feature no front-end load, but the broker who sells it is paid a full commission at the time of sale. To pay that commission, these funds carry a 1% 12b-1 fee and a declining redemption charge. (115) They may be convertible into Class A shares some years into the future. (116) Another typical load fund class of shares, Class C shares, often carries a CDSC of 1% if redeemed during the...