Rule 12b-1's requirements.

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

Rule 12b-1 classifies as a "distributor" of securities a mutual fund that pays distribution expenses for selling its shares out of its own assets; it then regulates when and how such payments can be made by the fund. A fund functions as distributor by financing any activity primarily intended to result in the sale of fund shares. The rule thus reaches every mutual fund that uses fund assets for such things as advertising, underwriter compensation, payments for dealers and sales personnel, the printing and mailing of prospectuses to non-shareholders, and the printing and mailing of sales literature. (95) Stated differently, "rule 12b-1 under the 1940 Act is the exclusive means by which a fund may bear the cost of selling, marketing, or promotional expenses associated with the distribution of its shares." (96)

The rule sets forth a number of requirements relating to the adoption and renewal of 12b-1 plans. In general, funds are barred from paying for distribution unless all fund distribution expenses are made pursuant to a written plan adopted in accordance with the rule (a "12b-1 plan"). Rule 12b-1 aims to make sure that a fund's financially independent directors are (1) not unduly influenced by the external adviser, (2) fully informed, and (3) able to exercise a reasonable business judgment. In an effort to protect against the fund's adviser using undue influence to extract fees, the rule provides that a 12b-1 plan and any related agreements must be initially approved by a majority of the fund's shareholders, and by both a majority of the fund's board of directors, and a majority of the fund directors who are not interested persons of the fund and who have no direct or indirect financial interest in the operation of the plan or in any related agreements. Directors are expressly required to collect and study relevant data before voting. (97) In particular, the directors have a duty under the rule to request and evaluate the information reasonably necessary to making an informed decision of whether to adopt or continue a 12b-1 plan.

The rule also requires that each 12b-1 plan and any related agreements contain certain terms. The plan and agreements are each required to continue in...