V. Rule 12b-1 in Practice

A. 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 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) B. 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 had two options. They could buy of a load fund through broker-dealers or other professionals, paying a sales charge of up to 8.5%, or they could buy 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 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 with different attributes. The B depicted in Table 1 below differ from other classes of typically offered by the same load funds. A 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, B may feature no front-end 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 A some years into the future. (116) Another typical load fund class of C often carries a CDSC of 1% if redeemed during the first year, a 1% 12b-1 fee charged yearly, and, in contrast to B may not be redeemable into A shares. (117) To appreciate the significance of the CDSCs' development and the competitive pressures CDSCs have exerted, it is necessary to understand how selling effort is compensated for load funds. For a load fund, a sales charge or load, such as 6% of the amount invested, would be deducted directly at the time of sale and used to compensate the sales representative and the selling organization. The load cuts the investor's equity at the front end, meaning less money is put to work to earn a return. CDSC evolved into a form of sales load that enabled load fund marketers to have their cake and eat it too. This is done by connecting a level 12b-1 fee to a redemption fee, i.e, the CDSC. The combined use of 12b-1 fees with CDSCs allowed load funds marketers to pay large front-end commissions without appearing to do so. A fund that might have formerly charged a 6% front-end sales load that was visible to the investor became able to compensate retailers at the same rate up front, recouping the cash advanced from the shareholder through a combination of 12b-1 fees and CDSCs. The fund would accomplish this by calling the old front-end fee investment Class A shares, while branding as Class B shares interests in the same portfolio sold by brokers compensated by means of CDSCs. …