By James Hamilton, J.D., LL.M.
The review of 1940 Act Rule 12b-1 is a high priority for the Division of Investment Management this year announced Director Andrew Donahue in a keynote address to a mutual funds conference in Palm Desert, California. The staff will be reconsidering both the rule itself and the factors that fund boards must consider when approving or renewing a Rule 12b-1 plan. Rule 12b-1 permits mutual funds to bear expenses associated with the distribution of their shares, if they comply with certain conditions and procedures. Separately, the director also expressed grave concern with funds’ increasing use of derivatives.
The rule was adopted in 1980 during an entirely different era of net redemptions amid a fear that funds may not survive unless they were permitted to use a at least a small portion of their assets to facilitate distribution. At over $10 trillion in assets, the director noted, the fund industry does not seem to be in imminent threat of extinction. Further, the industry has not been through a recent period of sustained net redemptions.
Indeed, mutual funds are enjoying growing popularity and acceptance by average investors. Not surprisingly, in light of these developments, the primary use of 12b-1 fees has shifted from the limited marketing and advertising purposes that were originally envisioned to using such fees primarily as a substitute for a sales load or for servicing. Against that backdrop, and with a forward-looking perspective, he feels that it would be wise to reconsider Rule 12b-1.
In a December 2000 report on mutual fund fees and expenses, the SEC staff recommended that the Commission consider whether Rule 12b-1 needs to be modified to accommodate changes in the mutual fund industry. The study also suggested that the Commission consider whether to give additional or different guidance to fund directors with respect to their review of Rule 12b-1 plans.
On a separate matter, the SEC official has multiple concerns about the increasing use by funds of derivatives and other sophisticated financial instruments. For example, he said it is imperative that all relevant parts of a fund’s operations team understand a portfolio instrument and appreciate its use and implications. The portfolio manager and investment officers will be involved in the decision to use a new type of financial instrument. In addition, the legal, compliance and accounting groups must also understand the instrument and have implemented the proper techniques and controls.
There is additional concern because the compliance systems at many funds may not be sophisticated enough to effectively handle synthetic instruments. Since these instruments generally emanate from the sell side, he noted, it is the sell side that has the systems to manage them and the experience to better deal with their risks, pricing and volatility. Mutual funds, on the other hand, very often are newcomers. The director was not warning funds off investing in these instruments, but rather that they should do a lot of work up front before wading into uncharted territory. In this way, he concluded, the fund and its investors will not be disappointed later.