Mutual Fund 12b-1 Fees: Key Reform Proposals

Mutual Fund 12b-1 Fees: Key Reform Proposals

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Pr
epared for Members and Committees of Congress

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Rule 12b-1 was adopted by the Securities and Exchange Commission (SEC) in 1980 pursuant to
the Investment Company Act of 1940 (ICA). The rule allows funds whose boards approve 12b-1
plans (structures) under the rule to draw from fund shareholders’ aggregate assets to market or
advertise and distribute (sell) fund shares, something they had not been allowed to do.
Prior to 1981, funds were allowed only one means of compensating the broker who sold them, the
“front-end load.” But in 1980, the SEC adopted Rule 12b-1, after years of lobbying from various
funds who cited financial hardships and a need to use fund assets to underwrite expanded
marketing and distribution to boost their size, viability, ultimately lowering their investors’ costs.
The rule allows funds to deduct a percentage of a fund’s assets each year to pay the broker an
annual fee, the 12b-1 fee. Initially, the agency expected that 12b-1 fees would be a temporary fix
to help smaller struggling no-load funds to grow healthier. But fund companies began using the
fee to either eliminate or to offset front-end loads as well. Now, the vast majority of funds levy
12b-1 fees. The research consensus is that 12b-1 plans do not appear to have helped to lower fund
investors’ costs as was originally hoped. They have, however, helped to provide them with the
benefit of greater choice in the fund payment structures available to them. But some broker-
dealers who sell the funds may not be steering investors into the most beneficial structures.
Reports indicate that a minority of funds, that are closed to new investors, still charge 12b-1 fees.
Though the practice is permissible, critics condemn it as violation of Rule 12b-1’s original intent,
allowing asset-based funding to attract new fund investors. Funds, fund distributors, and some
independent industry observers, however, say that investors in closed funds still demand and
receive attention from broker-dealers who may have sold a fund to them years ago and 12b-1 fees
still need to be collected to continue to pay for those services.
In a February 2004 proposal, the SEC asked for public comment on the need for additional
changes to Rule 12b-1. Among other things, it proposed requiring distribution-related costs to be
directly deducted from individual shareholder accounts rather than from aggregate fund assets,
potentially benefitting investors by giving them a more direct and thus a better understanding of
sales charges. But critics say such reform would result in investor’s accounts eventually paying
smaller nominal amounts as they age, giving broker-dealers added incentive to churn the
accounts. There are additional concerns that such changes might result in complicated record-
keeping burdens and added tax liabilities for investors. The 2004 proposal, also asked for public
comment on whether Rule 12b-1 should be repealed. But some observers have, however, noted
that the plans are ingrained in the financial system and repeal could mean reduced service for
small investors by brokers and a shift to front-end loads, which do have the benefit of greater
visibility relative to 12b-1 fees. In the spring of 2007, SEC Chairman Cox announced that due to
perceptions that 12b-1 fees had strayed beyond their original intent, the agency would be
reexamining 12b-1, which it is currently doing. If the agency adopts reforms, it might possibly
involve changes to the way 12b-1 fees are disclosed. H.R. 3225 (Castle) would direct the SEC to
improve the disclosure of fund fees and expenses.

˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

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The Origins of Rule 12b-1............................................................................................................... 1
The Role of 12b-1 Fees in the Overall Scheme of Fund Fees ......................................................... 2
Costs and Benefits of 12b-1 Fees .................................................................................................... 3
Disclosure Reform........................................................................................................................... 5
Closed Funds and 12b-1 Fees.......................................................................................................... 6
Amending the Treatment of 12b-1 Fees .......................................................................................... 7
Repealing Rule 12b-1 ...................................................................................................................... 8
The NASD Task Force .................................................................................................................. 10
Spring 2007: SEC Officials Say the Agency will Reexamine 12B-1 Fees.....................................11

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Author Contact Information .......................................................................................................... 12

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Section 22d of the Investment Company Act of 1940 (ICA) requires a mutual fund to set the same
fee for all brokers who sell the fund. From 1940 to 1981, the SEC, empowered by this act to
regulate funds, allowed only one type of broker compensation—the “front-end load.” If an
investor wanted the services of a broker, he or she paid a percentage of the money invested at the
time of the investment and nothing more.
In the late 1970s, various mutual funds confronted a troubling outflow of fund assets and the
industry lobbied the SEC to allow it to use fund assets to underwrite expanded marketing and
distribution, thereby boosting funds’ size and viability. In 1980, after substantial lobbying from
mutual funds, the SEC adopted Rule 12b-1, which allows funds to deduct a percentage of the
fund’s assets each year to pay the broker an annual fee, the 12b-1 fee.1 In doing so, the agency
reversed its long-held position that a fund’s assets should not be used to help sell more fund
shares and made it legal to use such money to pay for marketing and distribution expenses.
Initially, the SEC expected that 12b-1 fees would be a temporary fix to help smaller struggling
no-load funds become financially viable.2 But fund companies began using the fee to either
eliminate or to offset front-end loads, which were running as high as 8.5% during the 1980s.
Later, the revenue from 12b-1 fees was also applied to the cost of selling funds through large
financial product “supermarkets” like Charles Schwab’s OneSource.
The SEC shares regulatory responsibility over the 12b-1 fees with the Financial Industry
Regulatory Authority (FINRA), a non-governmental regulator for all securities firms that do
business in the United States.3 FINRA limits the annual rate at which 12b-1 fees may be paid to
broker-dealers to no more than 0.75% of a fund’s average net assets per year. Funds are also
allowed to include an additional service fee of up to 0.25% of average net assets each year to
compensate sales professionals for providing ongoing services to investors or for maintaining
their accounts.
According to the Investment Company Institute (ICI), the major mutual fund national trade
group, about 70% of all funds currently levy 12b-1 fees. In 2004, ICI reported that 40% of 12b-1
fees were used for compensation to financial advisors for initial assistance in helping investors

1 The agency’s adoption of rule 12b-1 pursuant to the ICA is an example of the rulemaking process under which federal
agencies implement federal laws. In the securities areas, major legislation such as the Securities Act of 1933, the
Securities Exchange Act of 1934, and the ICA, provide the framework for the SEC’s oversight of the securities
markets. The statutes tend to be broadly drafted and largely focused on establishing basic principles and objectives. The
SEC’s central goals are to maintain fair and orderly markets and to protect investors. To carry out these goals as
securities markets have evolved, the agency has used the authority granted to it under the laws to amend its regulations
or to adopt new ones.
2 A central controversy surrounding the SEC’s decision to permit the fees is between those who assert that the fees
were largely a response to the financial needs of a floundering fund industry and were only intended to be a “temporary
fix” and those who disagree, characterizing the assertions as misperceptions. At an SEC-sponsored roundtable on 12b-1
fees in June 2007, some former SEC staffers who were involved in implementing the 12b-1 fee rule reportedly
observed that such the assertions were not true.
3 In 2007, FINRA merged the NASD and the member regulation, enforcement and arbitration functions of the New
York Stock Exchange. Heretofore, the NASD (formerly the National Association of Securities Dealers), established
under the 1938 Maloney Act Amendments to the Securities Exchange Act of 1934, had responsibility for regulating
every broker-dealer in the United States with a public securities business, which included setting the parameters for
12b-1 fees.
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select the funds, 52% went to ongoing shareholder services, 6% went to fund underwriters, and
2% went to advertising and promotion, the original purpose of the fees.
‘Žȱ˜•Žȱ˜?ȱŗŘ‹ȬŗȱŽŽœȱ’—ȱ?‘ŽȱŸŽ›Š••ȱŒ‘Ž–Žȱ˜?ȱ
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Shareholders are assessed a number of fees and expense charges in return for the opportunity to
invest in mutual funds. There are two broad categories of costs: transaction fees and annual
operating expenses. Transaction fees are costs that are charged directly to the shareholder’s
accounts for specific transactions and include sales loads, and redemption fees. Ongoing or
annual operating expenses are costs associated with the normal cost of operating funds such as
maintaining offices and staff. They include asset-based charges like management fees and 12b-1
fees. In contrast to transaction fees, these costs are not charged directly to an investor’s account,
but are deducted from fund assets prior to the earnings being distributed to shareholders. The
various components of the annual operating expenses combine to form the expense ratio, the
central gauge of a fund’s costs vis-a-vis the value of its assets. A fund is often composed of a
number of generic classes, each with a claim on the same underlying assets. Thus, the classes
have identical performance characteristics. Where the classes do differ is in the way that their
transaction fees or their annual operating expenses are structured.
These generic fund classes and their constituent fees, including their 12b-1 fees are described
below:
• Class A shares charge investors a transaction fee called a front-end sales load.
The fee is generally associated with the purchase of fund shares and is used to
compensate financial professionals such as brokers and financial planners for
their services in marketing the funds. Legally, such charges can never exceed
8.5% of the amount invested; the fees tend to be in the 4% to 6% range. They
may also include a 12b-1 fee.
• Class B shares generally have no up-front charge, although occasionally they
may impose an up-front transaction fee that is smaller than what is charged by
Class A shares. Instead, they generally have transaction fees called contingent
deferred sales or redemption fees that are charged when shareholders redeem
their shares. These fees generally range between 5% and 7% of assets and usually
decline over time, disappearing after several years. The intermediaries who sell
Class B shares to investors are paid a commission by the fund companies who
generally then recoup that money from their shareholders in two basic ways: 1)
via the back-end charge described above; and 2) sometimes through 12b-1 fees
that range from 0.25% to 1.0% of assets. After several years, B shares may
convert to A shares. Before 1980, most mutual funds were Class A-type, front-
end load funds.
• Class C shares generally charge no up-front or back-end fee, although some
impose redemption fees if investors redeem shares within a couple of years.
Class C shares generally carry the highest 12b-1 fees, usually 1% a year. And
unlike class B shares, C shares usually do not convert to other classes with lower
12b-1 fees. The intermediaries who sell the shares generally get their
commissions from the fund company which relies substantially on the proceeds
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from 12b-1 fees to pay the commissions. The number of Class C shares that are
pure no-loads, defined as shares that do not impose front-end charges,
redemption charges, or 12b-1 fees, have been in steady decline through the years.
In the early 1990s, Class C shares with 12b-1 fees below 0.25% annually were
allowed to call themselves no-loads.
After the SEC permitted the use of 12b-1 fees in 1980, Class B shares that combine a 12b-1 fee
and a contingent deferred sales charge grew markedly, while ownership of front-end load funds
plummeted despite a significant overall decline in load size. In contrast to an observed
indifference to the impact of annual operating expenses, investors are generally identified as
being more sensitive to front-end loads in part because they are clearly identified as deductions
from an investor’s initial investments in the fund investor’s account statement.4
No-load funds were a small part of the mutual fund landscape until the 1970s, when companies
like Dreyfus, Vanguard, and Fidelity dropped their front load funds and began selling pure no
loads directly to the public. But as the size of fund investments held by the average investor rose,
demand for financial intermediaries who can guide them in their investment decisions has grown
apace. Likewise, the dramatic growth in the number of funds has also boosted the demand for the
intermediaries’ guidance and load funds—a development that has been at the expense of the no-
loads. And while loads have replaced no-loads, the sizes of the load have fallen, a development
that is at least in part traceable to the increased use of 12b-1 fees as a partial substitute for them.
˜œ?œȱŠ—?ȱŽ—Ž?’?œȱ˜?ȱŗŘ‹ȬŗȱŽŽœȱ
As discussed earlier, the intent behind the SEC’s adoption of rule 12b-1 was that the fee would
help underwrite expanded distribution and marketing, resulting in fund economies of scale that
would ultimately benefit fund shareholders: With an expansion in fund size, the assumption was
that the fixed costs of fund management would be spread over a larger base of assets, resulting in
a reduced average cost of management per fund investor dollar. There was additional hope that a
more consistent inflow of new investor cash would mitigate some of the volatility of fund
deposits and redemption flows. It was also thought that this would allow funds to hold less cash
and invest more of the fund’s assets, yielding increased returns to the fund.
Research conducted by SEC on the question of whether 12b-1 plans have helped funds to grow to
the benefit of shareholders found that the plans generally helped funds to grow faster than non-
12b-1 funds. It also found that shareholders have not benefitted through lower average expenses
or lower flow volatility. Fund manager compensation generally grows with the size of the fund
assets under their management and the research concluded that fund managers were the true
beneficiaries of 12b-1-based fund growth.5 It joined some earlier studies that found a positive

4 U.S. General Accounting Office, Mutual Fund Fees: Additional Disclosure Could Encourage Price Competition,
GAO-04-317 T, June 2000, p. 75.
5 Lori Walsh, “The Costs and Benefits to Fund Shareholders of 12b-1 Plans: An Examination of Fund Flows, Expenses
and Returns,” SEC Office of Economic Analysis, 2004.
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correlation between a fund’s 12b-1 fee and its expense ratio,6 some concluding that 12b-1 fees
impose a deadweight loss7 on mutual fund investors.8
Another study found that the link between 12b-1 fees and holding-period returns is a complicated
one. And among the complicating factors are the length of time an investor holds a fund, the size
of any front or deferred load, the size of the 12b-1 fee itself, and other details of a mutual fund’s
fee arrangement. For example, it noted that investors with short horizons will tend to be better off
paying a higher-than-average 12b-1 fee (thus incurring a higher-than-average expense ratio) to
avoid paying higher front loads. But, overall, it concluded that current fund fee structures do not
generally allow for definitive judgments on the shareholder welfare implications of 12b-1 plans
and expense ratios without taking account of the complicating roles played by front and deferred
loads.9
Some observers, however, argue that this kind of research on the cost implications of 12b-plans is
misguided given the contemporary realities of how the plans are actually used: It is widely agreed
that the 12b-1 fees have largely become alternatives to front-end loads, alternatives that have
given fund shareholders greater investment choices. Thus they argue that research on the way in
which the fees have or have not contributed to lower shareholder costs has thus become
irrelevant.10
Instead, they emphasize the role 12b-1 plans have played in the creation of the various fund fee
classes that are described above—structures that give investors a range of choices with respect to
various fee structures and payment arrangements. As a rule, economic theory says that there
should be a positive correlation between a consumer’s level of satisfaction and the number of
choices a consumer has.
But this benefit may be mitigated by the way in which the multi-class share structure may foster
confusion among investors to the benefit of the broker-dealer. Class B shares do not impose a
front-end sales charge, but they may charge higher expenses that investors are assessed over the
lifetime of their investment in a fund as compared to Class A shares. Class B shares also normally
impose a contingent deferred sales charge (CDSC), which you pay if you sell your shares within a
certain number of years. B shares may appear to be more appealing to investors than shares with a
front-end sales load such as A shares but they may have higher long-term costs; broker-dealers
may be relatively better compensated for selling them, giving them added incentives to push the
shares, incentives that investor may not be well informed about.
In early 2005, a number of fund companies, including the large Franklin Templeton family,
announced that they would no longer be selling Class B shares.11

6 When Rule 12b-1 was adopted, SEC officials appears to have hoped that the 12b-1 fees would allow fund firms to
grow, eventually attaining scale economies that would lower their expense ratios.
7 A deadweight loss is defined as the value of real resources lost to some type of market inefficiency.
8 For example, see the various studies identified in Sean Collins, “The Effect of 12b-1 Plans on Mutual Fund
Investors,” Investment Company Institute, March 2004.
9 Sean Collins, “The Effect of 12b-1 Plans on Mutual Fund Investors.” In one example, the study noted that investors
with short horizons will tend to be better off paying higher-than-average 12b-1 fees (with higher-than-average expense
ratio) in lieu of paying a front load.
10 For example, see Letter from Matthew Fink, president of the Investment Company Institute, to William H.
Donaldson, chairman U.S. Securities and Exchange Commission May 24, 2002.
11 Steven Goldberg, “Bye-Bye B Shares,” Kiplinger’s Personal Finance Magazine, February 2005.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
Śȱ

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The mandatory disclosure of financial information deemed important for investors to make
rational decisions is the centerpiece of the federal securities regulatory system overseen by the
SEC. Because of the continually changing nature of the nation’s financial landscape, the body of
required disclosures continues to be revisited. Such is the case with mandatory 12b-1 fee
disclosures.
When a fund charges a 12b-1 fee, it is identified as a line item in the fund prospectus fee table as
part of the fund’s annual operating expenses. The fee is also incorporated in the fund’s total
annual operating expense disclosed in the fee table and in the hypothetical example of fund
expenses that accompanies the fee table. Funds that levy a 12b-1 fee must also disclose in their
prospectuses that 12b-1 fees will increase the cost of an investment in the fund and may cost the
investor more than paying other types of sales charges. However, the disclosure protocol has been
criticized for being insufficiently revealing. Various investor advocacy groups say that many fund
investors do not understand that when they avoid funds with loads they may still be paying for
marketing costs indirectly through continuous 12b-1 fees. There are related concerns over what
some perceive to be a widespread lack of investor awareness of the significance of 12b-1 fees and
their contribution to total fund costs. Lipper found that while the average large-cap core stock
fund gave 0.68% of its assets to its advisers, it charges a nearly identical 0.64% to pay for 12b-1
marketing fees.12 The research firm has also identified inadequate disclosure as the central
problem with 12b-1 fees, noting that most fund prospectuses do not identify where the fees go.13
Some observers argue that there should be additional mandatory disclosure among fund
companies concerning 12b-1 fees, particularly concerning how they are used and how they are
charged. The expanded disclosure would ostensibly enable fund investors to make more informed
decisions.
But the science of securities and fund investor disclosure is a very inexact discipline. The “bottom
line” issue of whether a prospective disclosure is meaningful and useable will vary depending on
a host of key factors, including (1) the clarity of the disclosure; (2) an investor’s level of financial
sophistication; and (3) the extent to which an investor is willing to invest time in examining the
disclosure documents.
It is widely acknowledged that at best, many fund investors do a very cursory reading of fund
disclosure documents. Through the years, in pursuit of more “investor friendly” documents, the
SEC has pushed for but not completely succeeded in requiring less minutiae-laden, more
streamlined key disclosure documents such as fund prospectuses. In addition to factors that may
influence the useability of disclosure data such as the clarity of the disclosure language, an
investor’s interest in reading disclosure data, and how financially sophisticated an investor is, an
additional factor may be the extent to which a document is characterized by “data overload”:
Some research indicates that when consumers confront too much data, they may tend to examine
an even smaller percentage of the overall information provided.14

12 John Waggoner, “SEC Proposals Aim to Tweak Fund Oversight,” USA Today, February 7, 2003, B-03.
13 Ellen Kelleher, “Closed Fees Come Under The Spotlight,” FinancialTimes.com, December 11, 2003.
14 For example, see Chip Heath, and R.P. Larrick, “Cognitive Repairs: How Organizational Practices Can Compensate
for Individual Shortcomings,” Review of Organizational Behavior, vol. 20, June 1998, pp. 1-38.
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The marginal production cost of requiring funds to include mandatory disclosures on how 12b-1
fees are used and how they are charged as part of their disclosure documents would be negligible.
The key concerns involve the disclosure’s usefulness for investors and the extent to which it
could contribute to potentially counterproductive disclosure data clutter or overload as discussed
above. New disclosure on the nuts and bolts of 12b-1 fees may run the risk of being dauntingly
complex for many unsophisticated investors. And the SEC has recently adopted and proposed a
number of additional fund disclosure requirements, heightening the potential for disclosure
overload from newly mandated disclosures. The clearest public beneficiaries from the 12b-1 fee
disclosures would probably be the minority of sophisticated fund investors—investors far less
likely to be confused or overwhelmed by such disclosures.
Because of concerns over the potential contribution of new 12b-1 fee disclosure to disclosure
document data overload, some argue that the public would be better served if the disclosures were
done through other means. One such alternative would be disclosing the data at the time when a
fund investor purchases fund shares from a broker-dealer, the point-of-sale: Broker-dealers would
be required to give fund investors information on the embedded 12b-1 fees when fund shares are
acquired. Transactions conducted by phone would probably involve oral disclosure. Face-to-face
transactions could either involve oral disclosure, or the provision of printed matter. Research
indicates that information that is transmitted verbally tends to be remembered better than
information that is read, suggesting that oral point-of-sale disclosures may have certain
advantages. But point-of-sale disclosures would still confront issues concerning their usefulness
posed by the complicated subject matter. Moreover, in contrast to mandatory fund disclosure
documents, regulators would have a much more limited ability to monitor and enforce the quality
of point-of-sale disclosures.
Currently, perhaps the least controversial and most widely embraced disclosure reform (which
includes support from the ICI) would involve scrapping the rather opaque 12b-1 designation and
replacing it with a more descriptive and meaningful identification.15
H.R. 3225, the Mutual Fund Fee Reform Act, was introduced in August 2007 by Representative
Michael Castle. The bill, which was referred to the House Financial Services Committee, would
“require the Securities and Exchange Commission to improve the disclosure of fees and
expenses” of mutual funds under “the Investment Company Act of 1940.”
•˜œŽ?ȱž—?œȱŠ—?ȱŗŘ‹ȬŗȱŽŽœȱ
The Investment Company Institute and Standard & Poor’s reported that in 2006, about 580 fund
classes that were closed to new investors also charged 12b-1 fees. These fees ranged from 0.02%
to the maximum rate of 1.00%. According to Standard & Poor’s, the average rate was 0.66%.16

15 The SEC staff is currently formulating a recommendation to the Commission that would permit funds to offer
securities using streamlined disclosures that would be given directly to investors and could provide investors with key
information in plain English and could include investment objectives and strategies, costs, risks, and historical returns.
The more detailed currently available investor fund information would still be available to investors and others who
desire them.
16 Reported in: Palash R. Ghosh, “Some Closed Mutual Funds Are Charging 12b-1 Fees,” The Mutual Fund Focus
Newsletter, March 1, 2006.
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Although the practice of charging a 12b-1 fee to investors in closed funds is legal, S&P officials
and others have said that the existence of closed funds that still charge 12b-1 fees as a clear
violation of the intent behind Rule 12b-1, that fund assets should be used for marketing and
distribution to generate new sales of fund shares.17 Funds, fund distributors, and some
independent industry observers, however, say that investors in closed funds still demand and
receive attention from broker-dealers who may have sold a fund to them years ago and 12b-1 fees
still need to be collected to pay for these services as well. It is also argued that closed funds still
remain open to existing shareholders if they want to buy more shares, and that the funds use
ongoing annual 12b-1 fee payments to recoup front-end commissions that they advanced to the
fund distributor, a period often lasting six or seven years.
Information on details such as how long the funds that still charge 12b-1 fees have been closed
relative to those that are closed and no longer charge the fees are not available. But on the face of
it, the existence of the large number of closed funds that do not currently charge 12b-1 fees would
appear to help undercut arguments defending the practice.18
Representative Castle indicated that “it is not fair that investors in closed funds be subject to a fee
that’s purpose is to support marketing and distribution when the fund is no longer open to new
investors.”19
–Ž—?’—?ȱ?‘Žȱ›ŽŠ?–Ž—?ȱ˜?ȱŗŘ‹ȬŗȱŽŽœȱ
In a proposal released in February 2004, the SEC asked for public comment on the need for
additional changes to Rule 12b-1. Among other things, it proposed requiring distribution-related
costs to be directly deducted from individual shareholder accounts rather than from aggregate
fund assets.20

17 Chris Frankie, “S&P 12b-1 Fee Report Irritates Industry,” Money Management Executive, August 18, 2003.
18 H.R. 2179 (Baker), legislation introduced in the 108th Congress, was primarily aimed at giving the SEC additional
tools to protect investors. But as reported by the House Financial Services Committee in February 2004, the bill also
contained an amendment introduced by Representative Mike Castle, which would have banned the use of 12b-1 fees by
funds closed to new investors.
19 “Rep. Castle Amendment Banning 12b-1 Fund Fees on Closed Funds Included in Larger Securities Fraud Bill,”
States News Service, February 25, 2004.
20 “Prohibition on the Use of Brokerage Commissions to Finance Distribution, Proposed Rule by the Securities and
Exchange Commission” (Release No. IC-26356; File No. S7-09-04), February 24, 2004. The proposal also called for
the repeal of an arrangement governed by Rule 12b-1 known as directed brokerage. Most funds are sold through fund
intermediaries like broker-dealers. This has combined with a decade-old explosion in the number of funds being
offered to produce vigorous interfund competition for “shelf space” at selling broker-dealers. Arrangements for shelf
space can include such things as a broker-dealer simply making a fund available to his clients—to a broker prominently
featuring a fund. Over the years, broker-dealers with large distribution networks have increasingly demanded that fund
advisers make payments for shelf space to supplement the sales loads and 12b-1 fees they receive when their retail
clients purchase fund shares.
Directed brokerage involves funds paying broker-dealers for shelf space. To do so, funds use part of the asset-based
commissions that they pay broker-dealers to execute trades for them to also compensate them for selling the fund’s
shares. Broker-dealers praise the arrangements for helping to subsidize more efficient, centralized, and accessible
environments for accommodating investors’ fund selection and financial planning needs. But the arrangements may
also pose a number of potential conflict of interest issues, issues that stem from the fact that they involve funds’ use of
brokerage firms for two unrelated purposes: (1) selling mutual funds to investors; and (2) executing securities trades.
Rule 12b-1 regulates how funds use their assets to reimburse brokers who sell fund shares to the public and thus
directed brokerage arrangements fall under it. In its February 2004 proposal, SEC officials cited several reasons why
(continued...)
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For example, an investor with $10,000 of the typical Class B shares of a fund currently
experiences the 12b-1 fee through a lower total return on the fund since the fee reduces the
expense ratio. But under the proposed change, the investor would more explicitly and more
directly pay for 12b-1-compensated services by periodic payments to his or her broker-dealer
through some share redemptions.
SEC officials suggested that the alternative scheme might better benefit fund shareholders
because actual sales charges would be clearer; they would not have to pay for sales to new
investors; and long-term shareholders would not pay 12b-1 fees that exceeded their fair share of
distribution costs.
Mutual funds and fund intermediaries like broker-dealers and financial planners have said that
given the services provided to fund investors, 12b-1 fees are quite reasonable, producing a
number of efficiencies. They also have argued that the fees provide middle income investors more
payment options, and might be the cheapest way to pay for certain shareholder services, like
ongoing investment advice, phone counseling, and reviewing investment strategies. Some fund
distributors acknowledged that deducting the 12b-1 fees from shareholder accounts would be
cleaner than the way they are currently deducted from the overall fund. But they had larger
concerns that such a system would generate investor confusion, by making investors think 12b-1
fees go straight to the broker-dealer or investment adviser. Others are concerned that because the
shareholder accounts would eventually pay smaller nominal amounts as they age, the risk that the
broker-dealer would trade the account may increase, increasing the possibility of churning. And
there are other concerns that the proposal would result in complicated record-keeping burdens
and added tax liabilities for investors. But others question the claim that the proposal would
trigger additional tax liabilities.21
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In its February 2004 proposal on Rule 12b-1, the SEC also requested public comment on whether
Rule 12b-1 should be repealed. Supporters of repeal basically say that funds’ use of rule 12b-1
has evolved far beyond what was originally expected. But most mutual funds and the distributors
who sell them generally say that given the services provided to fund investors, 12b-1 fees are
quite reasonable and Rule 12b-1 should remain as it is.22

(...continued)
directed brokerage arrangements may harm funds and their shareholders, including that the portion of brokerage
commissions that pay for distribution is not disclosed as an expense. They can give broker-dealers financial incentives
to recommend to customers the funds that provide the best compensation to the broker, instead of the funds that are
best for the client; and they can increase a fund adviser’s advisory fees and reduce their out-of-pocket expenses for
distribution. In August 2004, the SEC commissioners adopted the staff recommendation that directed brokerage be
prohibited, a recommendation that earned wide-ranging support, including the backing of investor advocacy groups, the
Investment Company Institute, the Securities Firm Trade Association, and the Securities Industry Association (now the
Securities Industry and Financial Markets Association, which merged the SIA with the Bond Market Association, an
association of firms involved in the bond market industry) . The directed brokerage ban went into effect on December
13, 2004.
21 For example, see the correspondence of Marshall Blume, Professor at the Wharton School of Business, to the SEC
regarding File No. S7 09-04, April 5, 2004.
22 Among other things, legislation introduced in the 108th Congress, S. 2059 (Fitzgerald), and H.R. 4505 (Gillmor)
would have repealed Rule 12b-1.
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The Investment Company Institute, the fund trade association group, has acknowledged that the
manner in which rule 12b-1 has evolved was at odds with the original intent of the SEC. But the
fund trade association has stressed that the ways in which the rule has been used were not at all
inconsistent with its administrative history: The rule’s adopting release stated that the rule was
intended to be sufficiently flexible to cover new distribution financing arrangements that might
emerge from the fund industry and that the agency would closely monitor the rule and make any
necessary adjustments.23
The trade group has also noted that through its various regulatory actions, including its
sanctioning of multi-class shares, the SEC has been an integral part of the creation of the
infrastructure supporting the 12b-1 fees.24 But through the years, the SEC has been not given
unqualified support to Rule 12b-1: Through the years, the agency has floated a number of
proposals meant to put curbs on the way the rule was being applied. For example, the agency
promulgated a number of proposed amendments to modify Rule 12b-1 in 1988, proposals which
sparked significant fund industry opposition.25 And in 1992, noting that while multi-class fund fee
structures had given fund investors greater choice, agency staff expressed serious concerns over
the role they potentially played in inhibiting interfund price competition, and recommended that
the agency propose legislation to permit the introduction of a new fund entity called a unified fee
investment company (UFIC) with a much simpler fee structure. The agency never adopted the
recommendation.26
The idea of repealing Rule 12b-1, however, confronts a reality in which 12b-1 fees have become
a deeply ingrained fixture of the mutual fund and the broker-dealer worlds: A report released by
Lipper in 2004 observed that dismantling or modifying the rule would “wreak havoc” on all
aspects of the financial services industry.27 SEC officials have also acknowledged the profound
impact that eliminating 12b-1 fees would probably have on the fund and broker-dealer
industries.28
More explicit perceptions of the probable impact of repealing Rule 12b-1 and 12b-1 fees include
the prospect that

23 “Bearing of Distribution Expenses by Mutual Funds,” SEC Release. No. IC-11414 (Rule 12b-1 Adopting Release),
October 28, 1980.
24 Ibid.
25 The proposals included limiting the use of excess distribution expense recoupment (expenditures beyond a 12b-1
plan’s maximum may be recouped in subsequent years); updating NASD limits on maximum sales charges to include
12b-1 fees; restricting the ability of funds to define themselves as “no-loads” when they charge 12b-1 fees; requiring
more methodical analysis between 12b-1 plan expenditures and shareholder benefits realized; formally validating that
12b-1 payments are within a range that would have been recognized at arms-length; and requiring annual shareholder
approval of 12b-1 plans. Only the “no-load fund” definition and the NASD sales charge cap rules on funds levying
12b-1 fees were adopted by the agency. Since then, the SEC has considered various revisions to Rule 12b-1 but some
observers suggest that it chose not to reexamine Rule 12b-1 per se probably because of limited resources and more
pressing concerns. For example, see Testimony of Jeffrey Keil, Vice President for Global Fiduciary Review, Lipper
Inc., in U.S. Congress, Senate Governmental Affairs Committee, Financial Management Subcommittee, January 27,
2004.
26 The UFICs would have had a single, fixed fee set by the fund’s investment manager and no separate sales charges or
redemption fees. In addition, all fund expenses, except brokerage commissions, and extraordinary expenses would be
paid from a single fee or from the manager’s own assets. The structure would not have been under Rule 12b-1’s ambit.
27 As reported in John Churchill, “ Not-So-Fine Print,” Registered Rep., March 1, 2004.
28 “Speech by the SEC Chairman: Introductory Statement at February 11, 2004, Open SEC Meeting.”
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• Broker-dealers may be more inclined to churn client accounts to recoup lost 12b-
1 fees by switching the accounts from one fund to another;
• Broker-dealers could be less inclined to market the Class A fund shares
(explained above) frequently described as the best type of product for many fund
investors;
• In return for lost 12b-1 fees, front end loads may increase; and
• The prospect that smaller investors may be ignored by financial professionals and
may thus be precluded from owning some funds.
If repeal were to result in a larger proportion of funds sold with front end loads, this would
translate into fewer structural choices for fund investors. In at least one area, it might benefit
investors: In contrast to front-end loads, 12b-1 plans permit investors to give greater
consideration to the time-related aspects of their investment goals. The plans do enable investors
to earn returns on the full amount of money they invest, rather than having a portion of their
assets immediately deducted (via the front end load) to compensate the fund distributor. But
front-end loads are one-time charges that are deducted before an investor’s assets are invested in a
fund. Thus, they are widely perceived to be much more clear and transparent to fund investors
than are the ongoing 12b-1 fees.
Moreover, the extent to which funds would respond to a ban on 12b-1 fees by raising their loads
is an open question. Some research on the fund purchase and sale decisions of over 30,000
households with accounts at a large U.S. discount brokerage firm found fund investors to be fairly
sensitive to funds with high transaction fees like front-end loads.29
In the absence of the 12b-1 fee structure, there are some concerns that smaller investors could be
particularly disadvantaged. But as in the scenario proposed by the SEC, if in exchange for their
services, broker-dealers are directly compensated by the fund investors—whether the investors
are big or small probably should not matter.
Any move to eliminate 12b-1 fees and to restructure the way that fund sellers are paid would
necessitate radical changes within mutual funds, including shareholder votes to eliminate the
multiple share classes.
‘ŽȱȱŠœ”ȱ˜›ŒŽȱ
In May 2004, an NASD Task Force aimed at considering ways to provide greater transparency to
mutual fund costs and distribution arrangements and to provide those ideas to the SEC began
operation. In November 2004, the Task Force submitted a number of recommendations to the
SEC regarding mutual fund portfolio transaction costs, including directed brokerage
arrangements, soft dollars and disclosure.30

29 Brad Barber, Terrance Odean, and Lu Zheng, The Behavior of Mutual Fund Investors,” UCLA’s Anderson School of
Business Working Papers, September 2000.
30 Soft dollars are payments made to a brokerage firm for its services through commission revenue instead of cash
payments.
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In the spring of 2005, with respect to 12b-1 plans, the Task Force formally recommended (1)
updating and modernizing the findings a fund board must make in approving a 12b-1 plans, (2)
changing the reference to those fees in the prospectus fee table to a less confusing title
(distribution and shareholder servicing fees), and (3) improving disclosure about the costs of B
shares and consideration of regulatory caps on B share sales and limitations on conversion
periods.
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During an April 2007 speech, SEC Chairman Christopher Cox observed that “... the original
premises of Rule 12b-1 seem highly suspect in today’s world. If ever it was justified to indulge an
irrebuttable presumption in favor of using fund assets to compensate brokers for sales of fund
shares, that time surely has passed. Collecting an annual fee from mutual fund investors that is
supposed to be used for marketing is no more consumer friendly than forcing cable TV
subscribers to pay a special fee of $250 a year so the cable company can advertise....”31
In response to these concerns, Chairman Cox announced that the SEC would be reexamining
Rule 12b-1 during 2007.32 He also noted that on June 19, 2007, the agency would be hosting a
roundtable discussion on issues surrounding 12b-1 fees, an event the SEC hoped would assist it in
reviewing the current uses of 12b-1 fees; how those fees affect retail investors; the interests of
independent directors, who must approve 12b-1 plans; and identify and evaluate the possibilities
for reforming the rule.33
The roundtable provided an opportunity for an eclectic array of interests with varying
perspectives on 12b-1 fees to express their views. The wide-ranging views presented at the event
ranged from an “it ain’t broke, so don’t fix it,” to a plea for the complete repeal of the fees and an
overhaul of the way funds pay brokers.34
The question of disclosure reform was also addressed. For example, Brad Barber, a professor of
finance at the University of California, observed that he would like to see investors being
provided with a disclosure that outlined in simple dollar terms the amount they pay in 12b-1 fees.
But Joseph Russo, the chairman and chief executive officer of Advantage Financial Group, Inc.
opined that there currently is “enormous disclosure” of 12b-1 fees.35
The panel also discussed the elemental issue of the name, 12b-1 fees, with some panelists
emphasizing that the name in and of itself can be very confusing and uninformative. A number of
panelists were also in agreement that more work needs to be done in explaining what the fees

31 “Speech by SEC Chairman to the Mutual Fund Directors Forum, Seventh Annual Policy Conference by Chairman
Christopher Cox,” April 13, 2007, available at http://www.sec.gov/news/speech/2007/spch041207cc.htm.
32 Ibid.
33 A link to the roundtable can be found at http://www.sec.gov/spotlight/rule12b-1.htm.
34 Hannah Glover, “Discord Over How, and Whether, to Fix Fund Fees,” Money Management Executive. American
Banker, June 28, 2007, p. 124.
35 Robert Schroede, “Mutual Fund Fees Come Into SEC Sights At Review,” Dow Jones Business News, June 19, 2007.
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do.36 And indeed, a number of funds voluntarily provide a breakdown of the broad uses to which
their 12b-1 fees are disbursed.
SEC officials present at the roundtable, including Chairman Cox, reportedly avoided tipping their
hands with respect to the direction that the agency might be heading on 12b-1 reform. But a
number of observers predict that if reform is forthcoming, it will possibly take the form of greater
12b-1 fee disclosure and tighter rules on what can and cannot be funded with 12b-1 fees.37

ž?‘˜›ȱ˜—?ŠŒ?ȱ —?˜›–Š?’˜—ȱ

Gary Shorter

Specialist in Financial Economics
gshorter@crs.loc.gov, 7-7772

36 Hannah Glover, “Discord Over How, and Whether, to Fix Fund Fees,” Money Management Executive. American
Banker, June 28, 2007, p. 124.
37 Kristen French, “The Looming Battle over 12b-1 Fees, Registered Rep., August 1, 2007. An unofficial transcript for
the roundtable can be found at http://64.233.169.104/search?q=cache:nAF9JLuxiVMJ:www.sec.gov/spotlight/rule12b-
1.htm+12b-1+and+roundtable+and+transcript&hl=en&ct=clnk&cd=2&gl=us.
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