[Federal Register Volume 69, Number 40 (Monday, March 1, 2004)]
[Proposed Rules]
[Pages 9726-9737]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-4426]



[[Page 9725]]

-----------------------------------------------------------------------

Part IV





Securities and Exchange Commission





-----------------------------------------------------------------------



17 CFR Part 270



Prohibition on the Use of Brokerage Commissions To Finance 
Distribution; Proposed Rule

  Federal Register / Vol. 69, No. 40 / Monday, March 1, 2004 / Proposed 
Rules  

[[Page 9726]]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release No. IC-26356; File No. S7-09-04]
RIN 3235-AJ07


Prohibition on the Use of Brokerage Commissions To Finance 
Distribution

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

-----------------------------------------------------------------------

SUMMARY: The Securities and Exchange Commission is publishing for 
comment amendments to the rule under the Investment Company Act of 1940 
that governs the use of assets of open-end management investment 
companies (``funds'') to distribute their shares. The amended rule 
would prohibit funds from paying for the distribution of their shares 
with brokerage commissions. The proposed amendments are designed to end 
a practice that is fraught with conflicts of interest and may be 
harmful to funds and fund shareholders.

DATES: Comments must be received on or before May 10, 2004.

ADDRESSES: To help us process and review your comments more 
efficiently, comments may be sent to us in either paper or electronic 
format. Comments should not be sent by both methods. Comments in paper 
format should be submitted in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609. Comments in electronic format may be 
submitted to the following e-mail address: [email protected]. All 
comment letters should refer to File No. S7-09-04; if e-mail is used, 
this file number should be included on the subject line. Comment 
letters will be available for public inspection and copying in the 
Commission's Public Reference Room, 450 Fifth Street, NW., Washington, 
DC 20549. Electronically submitted comment letters will also be posted 
on the Commission's Internet Web site (http://www.sec.gov).\1\
---------------------------------------------------------------------------

    \1\ We do not edit personal or identifying information, such as 
names or e-mail addresses, from electronic submissions. Submit only 
information you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: Hester Peirce, Senior Counsel, or 
Penelope W. Saltzman, Senior Counsel, at (202) 942-0690, Office of 
Regulatory Policy, Division of Investment Management, Securities and 
---------------------------------------------------------------------------
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission 
(``SEC'' or ``Commission'') is requesting public comment on proposed 
amendments to rule 12b-1 [17 CFR 270.12b-1] under the Investment 
Company Act of 1940 [15 U.S.C. 80a] (``Investment Company Act'' or 
``Act'').\2\ The Commission is also requesting comment on whether 
additional amendments to rule 12b-1 are needed to address other issues 
that have arisen under the rule.
---------------------------------------------------------------------------

    \2\ Unless otherwise noted, all references to statutory sections 
are to the Investment Company Act of 1940.
---------------------------------------------------------------------------

Table of Contents

I. Background
    A. Current Practices
    B. Current Regulatory Requirements
II. Discussion
    A. Proposed Ban on Directed Brokerage
    B. Policies and Procedures
III. General Request for Comment
IV. Request for Comment on Further Amendments to Rule 12b-1
V. Cost-Benefit Analysis
VI. Consideration of Promotion of Efficiency, Competition, and 
Capital Formation
VII. Paperwork Reduction Act
VIII. Initial Regulatory Flexibility Analysis
IX. Statutory Authority

I. Background

    Investment companies buy and sell large amounts of securities each 
year. In 2002 alone, mutual fund securities transactions totaled 
approximately $7.8 trillion.\3\ Fund advisers choose which broker or 
dealer will effect transactions (``executing broker''), and often use 
commissions from these transactions to reward brokers or dealers for 
selling fund shares (``selling brokers''). Recently, our staff examined 
a number of funds and broker-dealers to obtain a better understanding 
of how fund brokerage commissions are used by advisers to pay for the 
promotion and sale of fund shares and how this practice may affect 
funds and fund shareholders.
---------------------------------------------------------------------------

    \3\ Investment Company Institute, Mutual Fund Fact Book 83 
(2003) (reporting approximately $4 trillion in total purchases and 
approximately $3.8 trillion in total sales of portfolio securities 
by equity, hybrid, and bond funds). This figure does not include 
purchases and sales by money market funds.
---------------------------------------------------------------------------

    Our staff found that the use of brokerage commissions to facilitate 
the sale of fund shares is widespread among funds that rely on broker-
dealers to sell their shares. Selling brokers appear to have 
significant leverage over funds because the number of distribution 
channels is limited, and fund complexes compete to seek a prominent 
position in them.\4\ This leverage permits selling brokers to demand 
additional payments from fund advisers from their own assets (``revenue 
sharing'') or through the direction of fund brokerage. These payments 
can purchase prominence (or better ``shelf space'') in an increasingly 
crowded fund marketplace.\5\
---------------------------------------------------------------------------

    \4\ See Rich Blake, How High Can Costs Go?, Institutional 
Investor, May 2001, at 56, 62 (``With thousands of funds and just a 
handful of national full-service brokerages, wire houses like 
Merrill, PaineWebber, and Smith Barney held the upper hand.'').
    \5\ Id. at 62-63 (``Just as fund companies need to cut through 
the clutter of all the funds available for sale, they must also 
attract the attention of the average sales person, who might 
familiarize himself with just a handful of funds among hundreds in 
any given asset category.'').
---------------------------------------------------------------------------

    In many cases, meeting the increasing compensation demands of 
selling brokers has caused funds' distribution-related fees (i.e., 
sales loads \6\ and rule 12b-1 fees \7\) to reach the National 
Association of Securities Dealers (``NASD'') limits (or ``caps'') on 
such fees (which we describe below).\8\ Fund advisers often use 
brokerage commissions to generate additional revenue to finance 
distribution.\9\ Brokers have, in turn, based their demands for greater 
compensation from funds on the apparent availability of these 
supplemental revenues. As a result, funds have allocated, over time, an 
increasing share of their brokerage commissions to support 
distribution. Our staff estimates that brokerage commissions may 
compose approximately twenty percent of annual expenditures for fund 
distribution.
---------------------------------------------------------------------------

    \6\ Sales loads represent explicit charges paid by fund 
shareholders to reimburse the fund's principal underwriter and 
distributor for sales efforts on behalf of the fund. Investors may 
pay sales loads at the time of purchase (a ``front-end load'') or at 
the time of redemption (a ``back-end load''). See section 2(a)(35) 
of the Act [15 U.S.C. 80a-2(a)(35)] (defining the term ``sales 
load''); rule 22d-1 [17 CFR 270.22d-1] (exemption permitting 
scheduled variations in sales loads); and rule 6c-10 [17 CFR 270.6c-
10] (exemption permitting sales loads to be charged after purchase, 
but before or at the time of redemption).
    \7\ ``Rule 12b-1 fees'' or ``12b-1 fees'' are fees paid out of 
fund assets pursuant to a distribution plan adopted under rule 12b-1 
under the Act. 17 CFR 270.12b-1. See infra note and accompanying 
text.
    \8\ See infra note and accompanying text.
    \9\ See Rich Blake, Misdirected Brokerage, Institutional 
Investor, June 2003, at 47, 49 (``But there's another critical 
reason that fund companies have resisted including commission 
payments in a 12b-1 marketing plan. Doing so would cause them to 
exceed a NASD limit on how much any fund investor can be asked to 
pay in brokerage compensation.'').
---------------------------------------------------------------------------

A. Current Practices

    The broker's cost of executing large, institutional brokerage 
transactions such as those effected for funds is often substantially 
less than the commission (or mark-up or mark-down) \10\ that funds

[[Page 9727]]

actually pay on most of their transactions.\11\ The adviser to a fund 
complex, which controls the allocation of fund brokerage, can use the 
excess of brokerage commissions paid over execution costs to purchase 
goods or services from the executing broker or third parties. Fund 
advisers often choose to use excess brokerage commissions to buy a 
place for the fund in the selling broker's distribution network. The 
use of excess commissions to pay for distribution costs has resulted in 
intricate business arrangements between fund advisers and securities 
firms that sell their shares.
---------------------------------------------------------------------------

    \10\ Broker-dealers, at times, may execute portfolio securities 
transactions on a principal basis. In those cases, the firms would 
be compensated through mark-ups or mark-downs rather than through 
commissions. Nothing in this Release or our concept release, Request 
for Comments on Measures to Improve Disclosure of Mutual Fund 
Transaction Costs, Investment Company Act Release No. 26313 (Dec. 
18, 2003), is intended to modify our views expressed in a recent SEC 
Interpretation, Commission Guidance on the Scope of Section 28(e) of 
the Exchange Act, Exchange Act Release No. 45194 (Dec. 27, 2001).
    \11\ See, e.g., Miles Livingston and Edward S. O'Neal, Mutual 
Fund Brokerage Commissions, 19 J. Fin. Res. 273, 290 (1996) (``Fund 
managers on average pay substantially more than the commissions 
available to large traders. * * * Assuming an average attainable 
rate of 2 cents per share, two-thirds of the median commission per 
trade * * * is payment for services other than trade execution.''). 
See also Jennifer S. Conrad et al., Institutional Trading and Soft 
Dollars, 56 J. Fin. 397, 406 n.11 (2001).
---------------------------------------------------------------------------

    Under the simplest of these arrangements, an adviser directs 
transactions in fund portfolio securities to a selling broker. The 
selling broker executes trades on behalf of the fund and credits to the 
fund a portion of the commission it receives to pay for distribution-
related services. If the selling broker lacks the capacity to execute 
the fund's securities transactions, the adviser may implement a more 
complicated arrangement. The adviser may select another broker to 
execute the transaction and require the executing broker to ``step 
out'' a portion of its commission to pay the selling broker.\12\ 
Alternatively, the executing broker may retain a portion of the 
commission as compensation for its execution services and set the 
remainder aside pending the adviser's designation of the selling 
brokers to which the remainder will be directed.\13\ In an 
``introducing broker'' arrangement, a clearing broker executes the 
transaction, forwards the entire commission to the selling broker 
(``introducing broker''), and periodically charges the selling broker 
for its execution services.\14\
---------------------------------------------------------------------------

    \12\ Although the selling broker might not perform any execution 
services in connection with the portfolio transactions, it typically 
is responsible for the confirmation of a specified portion of the 
trade (i.e., a particular amount of securities). The excess of the 
selling broker's compensation over the value of its confirmation 
services in connection with the trade is compensation for the 
selling broker's distribution efforts.
    \13\ The adviser designates the recipient selling brokers 
periodically (e.g., quarterly). The selling brokers typically 
provide no services in connection with the fund's portfolio 
securities transactions.
    \14\ There are several variants on these arrangements for 
compensating the selling broker for distribution with commissions 
from a transaction that is executed primarily or exclusively by 
another broker.
---------------------------------------------------------------------------

    Some fund advisers and selling brokers enter into an agreement that 
sets forth a target dollar amount of commissions to be paid over a 
period of time to the selling broker as compensation for distributing 
fund shares.\15\ A typical arrangement covers all of the funds in a 
complex that are subject to sales or dealer agreements between the 
selling broker and the funds' principal underwriter.\16\ If the funds 
do not generate the specified dollar amount of commissions during the 
year, the difference may be paid by the funds' adviser or carried 
forward into the next year. If the selling broker's overall 
compensation for distributing the shares of a fund complex falls below 
agreed-upon levels, the selling broker may reduce its selling efforts 
for the funds. As described below, these arrangements are covered by 
rule 12b-1.
---------------------------------------------------------------------------

    \15\ See, e.g., Misdirected Brokerage, supra note, at 50 
(explaining that typically an executive of the adviser enters into 
an ``almost invariably oral agreement[]'' with an executive of the 
broker to trade a combination of cash, revenue sharing payments, and 
fund brokerage commissions ``for a precious commodity: privileged 
access to the brokerage's sales force'').
    \16\ These arrangements may raise issues under section 17(d) [15 
U.S.C. 80a-17(d)] of the Act and rule 17d-1 [17 CFR 270.17d-1] 
thereunder. Section 17(d) of the Act and rule 17d-1, prohibit funds 
from, among other things, entering into a joint enterprise or other 
joint arrangement or profit-sharing plan with any affiliated person, 
unless prior approval has been granted by Commission order. A fund 
may be an ``affiliated person'' of another fund if, for example, the 
funds are under the common control of the same investment adviser. 
See section 2(a)(3)(C) of the Investment Company Act [15 U.S.C. 80a-
2(a)(3)(C)]. Pursuant to rule 17d-1 under the Investment Company 
Act, affiliated funds may apply for an order from the Commission 
permitting the use of a joint arrangement to finance the 
distribution of their shares. See, e.g., College Retirement Equities 
Fund, Inc., Investment Company Act Release Nos. 19591 (July 23, 
1993) (notice) [58 FR 40681 (July 29, 1993)] and 19645 (Aug. 19, 
1993) (order). Absent such an order, an arrangement to compensate a 
selling broker for distribution on a complex-wide basis may 
constitute a prohibited joint distribution arrangement pursuant to 
which the brokerage commissions paid by one fund are used to finance 
the distribution of the shares of another fund in the same fund 
complex. See generally Payment of Asset-Based Sales Loads by 
Registered Open-End Management Investment Companies, Investment 
Company Act Release No. 16431 (June 13, 1988) [53 FR 23258 (June 21, 
1988)].
---------------------------------------------------------------------------

B. Current Regulatory Requirements

    Fund brokerage is an asset of the fund, and therefore must be used 
for the fund's benefit.\17\ Use of fund assets to pay selling brokers 
or otherwise finance the sale of fund shares is regulated by rule 12b-
1, which we adopted under our authority in section 12(b) of the 
Act.\18\ Section 12(b) makes it unlawful for a fund ``to act as a 
distributor of securities of which it is the issuer, except through an 
underwriter, in contravention of such rules and regulations'' as we 
prescribe. Section 12(b) was intended to protect funds from bearing 
excessive sales and promotion expenses.\19\ Rule 12b-1 permits funds to 
use their assets to pay distribution-related costs. In order to rely on 
rule 12b-1, a fund must adopt ``a written plan describing all material 
aspects of the proposed financing of distribution'' that is approved by 
fund shareholders and fund directors.\20\ We included these and other 
conditions in the rule to address concerns about the conflicts of 
interest arising from allowing funds to finance distribution.\21\
---------------------------------------------------------------------------

    \17\ See Electronic Filing by Investment Advisers; Proposed 
Amendments to Form ADV, Investment Advisers Act Release No. 1862 
(Apr. 5, 2000) [65 FR 20524 (Apr. 17, 2000)], at text following n. 
166 (``Client brokerage, however, is an asset of the client, not the 
adviser.''). See also American Bar Association, Fund Director's 
Guidebook, 59 Bus. Law. 201, 243 (2003) (``Brokerage commissions are 
assets of the fund, and the fund's directors are ultimately 
responsible for determining policies governing brokerage 
practices.''). But see Interpretive Release Concerning the Scope of 
Section 28(e) of the Securities Exchange Act of 1934 and Related 
Matters, Exchange Act Release No. 23170 (Apr. 23, 1986) [51 FR 16004 
(Apr. 30, 1986)] (``Section 28(e) Interpretive Release'') (noting 
that section 28(e) allows a money manager to consider benefits 
derived by other accounts he manages when determining the 
reasonableness of commissions an account is paying).
    \18\ 15 U.S.C. 80a-12(b).
    \19\ Investment Trusts and Investment Companies, Hearings on 
H.R. 10065 Before a Subcomm. of the House Comm. on Interstate and 
Foreign Commerce, 76th Cong., 3d Sess. 112 (1940) (statement of 
David Schenker).
    \20\ Rule 12b-1(b).
    \21\ Bearing of Distribution Expenses by Mutual Funds, 
Investment Company Act Release No. 11414 (Oct. 28, 1980) [45 FR 
73898 (Nov. 7, 1980)] (``1980 Adopting Release'').
---------------------------------------------------------------------------

    Rule 12b-1 does not itself limit the amount of distribution costs 
that a fund can assume, nor does it explicitly address the extent to 
which fund brokerage can be used to reward brokers for promoting the 
sale of fund shares. Two NASD rules address these matters.
    First, NASD Conduct Rule 2830(d) prohibits NASD members (i.e., 
broker-dealers) from selling shares of funds that impose excessive 
sales charges.\22\ The rule deems a sales charge to be excessive if it 
exceeds the rule's caps. A

[[Page 9728]]

fund's sales load (whether charged at the time of purchase or 
redemption) may not exceed 8.5 percent of the offering price if the 
fund does not charge a rule 12b-1 fee.\23\ The aggregate sales charges 
of a fund with a rule 12b-1 fee may not exceed 7.25 percent of the 
amount invested,\24\ and the amount of the asset-based sales charge 
(the rule 12b-1 fee) may not exceed 0.75 percent per year of the fund's 
average annual net assets.\25\ Under the cap, therefore, an increase in 
the fund's sales load could reduce the permissible level of payments a 
selling broker may receive in the form of 12b-1 fees. The NASD designed 
the rule so that cumulative charges for sales-related expenses, no 
matter how they are imposed, are subject to equivalent limitations.\26\
---------------------------------------------------------------------------

    \22\ NASD Conduct Rule 2830 (Investment Company Securities). 
Paragraph (d) (Sales Charge) prohibits members from selling the 
shares of a fund ``if the sales charges described in the prospectus 
are excessive.''
    \23\ NASD Conduct Rule 2830(d)(1)(A). If the fund also charges a 
service fee, the maximum aggregate sales charge may not exceed 7.25% 
of the offering price. NASD Conduct Rule 2830(d)(1)(D).
    \24\ NASD Conduct Rule 2830(d)(2)(B). If the fund also charges a 
service fee, the maximum aggregate sales charge may not exceed 6.25% 
of the amount invested. NASD Conduct Rule 2830(d)(2)(A).
    \25\ NASD Conduct Rule 2830(d)(2)(E)(i).
    \26\ The NASD, when it amended the sales charge rule to 
encompass asset-based sales charges (rule 12b-1 fees), explained its 
intention to ``assure a level playing field'':
    [Asset-based sales charges] are the only type of mutual fund 
sales compensation that currently is not subject to NASD regulation. 
With the advent of these new methods of assessing sales charges on 
mutual funds, the NASD believed the Rules of Fair Practice should be 
amended specifically to encompass all sales charges. The NASD 
desired to take steps to assure a level playing field among all 
members selling mutual fund shares. Moreover, it believed additional 
amendments were necessary to prevent circumvention of the existing 
maximum sales charge rule because it had become possible for funds 
to use 12b-1 plans, either separately or in combination with initial 
or deferred sales loads, to charge investors more for distribution 
than could have been charged as an initial sales load under the 
existing maximum sales charge rule.
    Order Approving Proposed Rule Change Relating to the Limitation 
of Asset-Based Sales Charges as Imposed by Investment Companies, 
Exchange Act Release No. 30897 (July 7, 1992) [57 FR 30985 (July 13, 
1992)], at text accompanying n. 9.
---------------------------------------------------------------------------

    Second, NASD Conduct Rule 2830(k), the ``Anti-Reciprocal Rule,'' 
prohibits NASD members from conditioning their efforts in distributing 
a fund's shares on the receipt of the fund's brokerage commissions.\27\ 
An exception to the Anti-Reciprocal Rule permits NASD members to sell 
shares of funds that follow a disclosed policy ``of considering sales 
of their shares as a factor in the selection of broker/dealers to 
execute portfolio transactions, subject to best execution.'' \28\ 
Broker-dealers may not, however, condition their promotion or sale of 
fund shares on the receipt of brokerage commissions from the fund.\29\
---------------------------------------------------------------------------

    \27\ NASD Conduct Rule 2830(k) (Execution of Investment Company 
Portfolio Transactions).
    \28\ NASD Conduct Rule 2830(k)(7)(B).
    \29\ See, e.g., infra note 42 (describing SEC and NASD actions 
relating to Morgan Stanley's program for giving marketing 
preferences to funds in exchange for cash and brokerage 
commissions).
---------------------------------------------------------------------------

    We approved this exception to the NASD's rules in 1981, shortly 
after adopting rule 12b-1.\30\ We concluded that, in light of the 
adoption of rule 12b-1, ``it is not inappropriate for investment 
companies to seek to promote the sale of their shares through the 
placement of brokerage without the incurring of any additional 
expense.'' \31\ We recognized the conflicts of interest and stated that 
we expected fund boards, before adopting a policy permitting the 
``consider[ation] of the sale of an investment company's shares as a 
factor in the selection of broker-dealers to execute portfolio 
transactions, subject to the requirements of best execution,'' to 
``carefully weigh the possible advantages to the investment company and 
its shareholders and the possible abuses that may stem from the 
adviser's use of portfolio brokerage to encourage the sale of 
investment company shares.'' \32\
---------------------------------------------------------------------------

    \30\ Order Approving Proposed Rule Change and Related 
Interpretation under Section 36 of the Investment Company Act, 
Investment Company Act Release No. 11662 (Mar. 4, 1981) [46 FR 16012 
(Mar. 10, 1981)] (``1981 Release'').
    \31\ Id. (emphasis added). Nonetheless, we emphasized that the 
directors of a fund have a ``continuing duty to assure that the 
company's brokerage allocation practices are designed to obtain best 
price and execution and to avoid any unnecessary trading.'' Id.
    \32\ Id. The exception to the Anti-Reciprocal Rule is 
conditioned on the fund disclosing its practice of considering 
distribution of its shares in selecting executing brokers. NASD 
Conduct Rule 2830(k)(7)(B).
---------------------------------------------------------------------------

    Because, as noted above, fund brokerage is an asset of the fund, a 
fund's use of its brokerage to promote the sale of its shares is 
generally viewed as a payment by the fund and thus subject to rule 12b-
1.\33\ In approving the exception to the NASD's Anti-Reciprocal Rule in 
1981, however, we concluded that the practice of merely considering 
selling brokers' sales efforts when allocating brokerage would be 
addressed by the NASD rules governing broker-dealers and advisers' 
fiduciary obligations to seek best execution, rather than by Commission 
rules governing the use of fund assets for distribution.
---------------------------------------------------------------------------

    \33\ Rule 12b-1 applies to both ``direct'' and ``indirect'' 
financing activity that is primarily intended to result in the sale 
of fund shares. Rule 12b-1(a)(2). When we adopted the rule, we noted 
that ``there can be no precise definition of what types of 
expenditures constitute indirect use of fund assets.'' 1980 Adopting 
Release, supra note.
---------------------------------------------------------------------------

II. Discussion

    Our decision in 1981 to approve the exception to the NASD's Anti-
Reciprocal Rule was based on a view that merely factoring sales efforts 
into the selection of brokers, consistent with the investment adviser's 
fiduciary duties to the fund, was essentially benign. When a fund could 
choose among several brokers that could provide best execution, a 
decision to favor a selling broker could be made ``without the 
incurring of any additional expense.'' \34\ Moreover, the ``mere 
allocation'' of brokerage to promote the sale of fund shares could 
benefit existing shareholders of funds that were in ``net redemption,'' 
that is, fund assets were shrinking and the ratio of fund expenses to 
fund assets was rising.
---------------------------------------------------------------------------

    \34\ 1981 Release, supra note 30.
---------------------------------------------------------------------------

    Our review of current practices, however, suggests that many 
arrangements that direct brokerage to reward selling brokers for 
distribution constitute more than mere allocation of brokerage, and are 
not consistent with our 1981 rationale for approving the exception to 
the NASD's Anti-Reciprocal Rule. The use of multiple broker-dealers for 
execution, step-outs, and other arrangements described above explicitly 
quantify the value of the distribution component of fund brokerage 
commissions and belie the notion that fund advisers are merely 
``considering'' the selling efforts of the broker(s) involved. Rather, 
these arrangements bear all the hallmarks of barter arrangements in 
which the fund advisers trade brokerage (a fund asset) for sales 
efforts. Moreover, that brokerage commissions could instead be used to 
offset other fund costs rebuts the notion that the use of fund 
brokerage to finance distribution imposes no additional costs on the 
fund. Foregoing an opportunity to seek lower commission rates, to use 
brokerage to pay custodial, transfer agency and other fund 
expenses,\35\ or to obtain any available cash rebates, is a real and 
meaningful cost to fund shareholders.
---------------------------------------------------------------------------

    \35\ See Payment for Investment Company Services with Brokerage 
Commissions, Investment Company Act Release No. 21221 (July 21, 
1995) [60 FR 38918 (July 28, 1995)] (requiring funds, in calculating 
the cost of various services, to account for amounts paid with 
commission dollars).
---------------------------------------------------------------------------

    While the benefits to funds and their shareholders of using fund 
brokerage to promote the sale of fund shares are unclear, the benefits 
to fund advisers are clear. Fund advisers' compensation is based on a 
percentage of assets under management. A larger fund typically 
generates more advisory fees. Fund advisers have an incentive to use 
fund assets to increase the size of the fund and therefore promote the 
growth of

[[Page 9729]]

their advisory fees.\36\ An adviser that uses fund assets to promote 
the sale of fund shares may be able to avoid having to pay fees out of 
its own pocket (``revenue sharing''). Although fund advisers have 
similar conflicts with respect to the use of other fund assets that 
flow through a rule 12b-1 plan, the use of fund brokerage exacerbates 
the conflicts and complicates efforts to control them because of the 
practical limitations on the ability of fund directors to monitor and 
evaluate the motivations behind the selection of brokers to effect 
portfolio securities transactions.\37\
---------------------------------------------------------------------------

    \36\ Bearing of Distribution Expenses by Mutual Funds, 
Investment Company Act Release No. 10252 (May 23, 1978) [43 FR 23589 
(May 31, 1978)], at text following n.5 (``The fact that mutual fund 
advisers are paid fees based on a percentage of the fund's assets 
causes the growth of the fund through the sale of additional shares 
generally to be in the adviser's interest.'').
    \37\ See, e.g., Letter from Matthew P. Fink, President, 
Investment Company Institute, to William H. Donaldson, Chairman, SEC 
(Dec. 16, 2003) (http://www.ici.org/statements/cmltr/03 --sec--
soft--com.html#P37--12572) (``ICI Letter'') (noting that the use of 
brokerage commissions to finance distribution ``can give rise to the 
appearance of a conflict of interest, as well as the potential for 
actual conflicts, given the fact-specific nature of the best 
execution determination'').
---------------------------------------------------------------------------

    We believe that the way brokerage has been used to pay for 
distribution involves unmanageable conflicts of interest that may harm 
funds and fund shareholders.\38\ The intense competition we observe 
among fund advisers to secure a prominent position in the selling 
brokers' distribution systems (``shelf space'') creates powerful 
incentives for fund advisers to direct brokerage based on distribution 
considerations rather than quality and price considerations. These 
incentives may adversely affect decisions about how and where to effect 
portfolio securities transactions, and thus affect the quality of 
portfolio transactions.\39\ Pressures to generate brokerage commissions 
may also lead to an increase in portfolio turnover rates, which may 
drive up fund costs and harm performance.\40\ At a minimum, this 
practice disadvantages funds that, because of investment 
considerations, do not actively trade their portfolios.\41\
---------------------------------------------------------------------------

    \38\ We came to a similar conclusion in 1966 when we examined 
similar reciprocal brokerage practices in a report to Congress 
discussing the public policy implications of investment company 
growth. Securities and Exchange Commission, Report on the Public 
Policy Implications of Investment Company Growth, H.R. Rep. No. 89-
2337, at 186 (1966) (``PPI Report'') (the use of brokerage 
commissions for sales of fund shares has ``an adverse effect on 
mutual funds and their shareholders''). At the time, the Commission 
believed that such practices could be addressed through reform of 
commission rate schedules by the securities exchanges to permit 
volume discounts on large trades. Id. at 187. See also Wharton 
School of Finance and Commerce, A Study of Mutual Funds, H.R. Rep. 
No. 87-2274, at 539 (1962). Even after the elimination of fixed 
commission rates, the problems identified in 1966 persist.
    \39\ See, e.g., Kent Knudson, Mutual Fund Distribution Payments: 
Navigating the Conflicts, 3 J. of Investment Compliance 25, 26 
(Winter 2002-2003) (noting that while any type of distribution 
payment gives rise to conflicts, ``it would seem that soft-dollar 
arrangements using fund commissions to incentivize or support 
dealers that sell fund shares pose heightened concerns, especially 
when such arrangements may encourage an adviser to pay more than 
going market rates for trading commissions''). See also In re 
Kingsley, Jennison, McNulty & Morse Inc., Investment Advisers Act 
Release No. 1396 (Dec. 23, 1993) [51 SEC 904] (finding conflict of 
interest in adviser's soft dollar arrangement with a broker even 
though the arrangement did not result in adviser's client paying 
higher than the market commission rate for transactions executed by 
the broker; conflict existed because by selecting that broker, the 
adviser avoided having to pay for the soft dollar benefits out of 
its own assets).
    \40\ PPI Report, supra note 38, at 174 (``A high portfolio 
turnover rate may result from a bona fide judgment that a policy of 
active trading is most likely to lead to optimum investment 
performance, especially during periods of great volatility. But it 
may also result from the managers' decision to generate a 
substantial volume of brokerage commissions for the purpose of 
stimulating the sale of new shares.''). See also Note, The Use of 
Brokerage Commissions to Promote Mutual Fund Sales: Time to Give Up 
the ``Give-Up'', 68 Colum. L. Rev. 334, 339 (1968) (``But even where 
true churning does not exist, the pressure to create give-ups may 
push a doubtful transaction over the line into execution.'') 
(footnote omitted).
    \41\ See PPI Report, supra note 38, at 17, 174, and 180.
---------------------------------------------------------------------------

    We are also concerned about the effect of this practice on the 
relationship between broker-dealers and their customers.\42\ Receipt of 
brokerage commissions by a broker-dealer in exchange for shelf space 
creates an incentive for the broker to recommend funds that best 
compensate the broker rather than ones that meet the customer's 
investment needs.\43\ Because of the lack of transparency of brokerage 
transactions and their value to a broker-dealer, customers may not have 
appreciated the extent of this conflict. Finally, the direction of 
valuable fund brokerage to compensate brokers for the sale of fund 
shares may permit brokers to circumvent the NASD's rules against 
excessive sales charges,\44\ thus undermining the protections afforded 
fund shareholders by those rules and by section 22(b) of the Act, which 
authorized them.\45\
---------------------------------------------------------------------------

    \42\ See, e.g., In re Morgan Stanley, Inc., Securities Act 
Release No. 8339 (Nov. 17, 2003) (finding broker-dealer had 
willfully violated section 17(a)(2) of the Securities Act [15 U.S.C. 
77q(a)(2)], rule 10b-10 [17 CFR 240.10b-10] under the Securities 
Exchange Act of 1934 (``Exchange Act''), and NASD Conduct Rule 
2830(k) by failing to disclose to its clients who purchased fund 
shares that it was being paid by certain fund companies, with a 
combination of cash and brokerage commissions, to make special 
efforts to market those funds); NASD Charges Morgan Stanley with 
Giving Preferential Treatment to Certain Mutual Funds in Exchange 
for Brokerage Commission Payments, NASD News Release (Nov. 17, 2003) 
(announcing companion NASD action for violation of NASD Conduct Rule 
2830(k) by, among other things, favoring the distribution of shares 
of particular funds on the basis of brokerage commissions to be paid 
by the funds). See also Laura Johannes and John Hechinger, 
Conflicting Interests: Why a Brokerage Giant Pushes Some Mediocre 
Mutual Funds, Wall St. J., Jan. 9, 2004, at A1.
    \43\ See Ruth Simon, Why Good Brokers Sell Bad Funds, Money, 
July 1991, at 94.
    \44\ See supra notes 22 through 26 and accompanying text.
    \45\ 15 U.S.C. 80a-22(b). Although we need not address the 
question today, the use of fund brokerage commissions to finance 
distribution for the economic benefit of the fund's adviser also 
raises troubling questions under section 17(e)(1) of the Investment 
Company Act. 15 U.S.C. 80a-17(e)(1) (making it unlawful for any 
affiliated person of a fund, ``acting as agent, to accept from any 
source any compensation * * * for the purchase or sale of any 
property to or for [the fund] except in the course of such person's 
business as an underwriter or broker''). See, e.g., In re Duff & 
Phelps Investment Management Co., Inc., Investment Company Act 
Release No. 25200 (Sept. 28, 2001) (finding that adviser ``willfully 
violated section 17(e)(1)'' by directing a fund's brokerage 
transactions to a broker-dealer in return for client referrals); In 
re Fleet Investment Advisors Inc. (as successor to Shawmut 
Investment Advisers, Inc.), Investment Advisers Act Release No. 1821 
(Sept. 9, 1999) (finding that affiliated adviser's receipt of client 
referrals in return for the direction of fund brokerage commissions 
was compensation in violation of section 17(e)(1)); In re Provident 
Management Corp., Investment Advisers Act Release No. 277 (Dec. 1, 
1970) (finding that fund affiliates violated and/or aided and 
abetted in the violation of section 17(e)(1) by directing fund 
brokerage to brokers that provided commission recapture and free 
sales material to the fund's primary retail distributor).
---------------------------------------------------------------------------

A. Proposed Ban on Directed Brokerage

    In light of these concerns, we are proposing amendments to rule 
12b-1 under the Act to prohibit funds from compensating a broker-dealer 
for promoting or selling fund shares by directing brokerage 
transactions to that broker.\46\ The rule would also prohibit step-out 
and similar arrangements designed to compensate selling brokers for 
selling fund shares.\47\
---------------------------------------------------------------------------

    \46\ Proposed rule 12b-1(h)(1). The rule would prohibit funds 
from financing distribution of fund shares through the direction of 
any service related to effecting a fund brokerage transaction, 
including performing or arranging for the performance of any 
function related to the processing of that transaction (e.g., 
transmission of an order for execution, execution of an order, or 
clearance and settlement of the transaction). The prohibition would 
include the direction of brokerage from transactions executed by 
government securities brokers and dealers and municipal securities 
dealers.
    \47\ Proposed rule 12b-1(h)(2). In addition to step-outs, the 
rule would prohibit, for example, the use of arrangements in which a 
portion of a fund's brokerage commissions are ``rebated'' to an 
account maintained for the fund and later paid to a selling broker.
---------------------------------------------------------------------------

    We request comment on the proposed ban on the use of brokerage 
commissions to pay brokers for selling fund shares.\48\
---------------------------------------------------------------------------

    \48\ We note that the NASD recently filed with us a proposed 
rule change to eliminate the exception to the Anti-Reciprocal Rule, 
which, as discussed above, permits NASD members to sell shares of 
funds that follow a disclosed policy ``of considering sales of their 
shares as a factor in the selection of broker/dealers to execute 
portfolio transactions, subject to best execution.'' NASD Conduct 
Rule 2830(k)(7)(B). The NASD's proposal also would prohibit a 
broker-dealer from selling a fund if the broker-dealer knows of an 
arrangement under which the fund directs portfolio securities 
transactions to pay for distribution of fund shares. Proposed 
Amendment to Rule Relating to Execution of Investment Company 
Portfolio Transactions, NASD Rule Filing 2004-027 (Feb. 10, 2004) 
(http://www.nasdr.com/pdf-text/rf04_27.pdf). Pursuant to Exchange 
Act Section 19(b) [15 USC. 78s(b)] and rule 19b-4 [17 CFR 240.19b-
4], we will publish notice of and seek comment on the NASD's 
proposed rule.

---------------------------------------------------------------------------

[[Page 9730]]

     Are our concerns about this practice justified?
     Are there alternative measures that we could 
take to address the use of brokerage commissions to finance 
distribution?
     Would brokerage commissions be reduced by 
eliminating the use of commissions to pay for distribution? Would there 
be greater competition in commission rates?
     If we ban this practice, would the primary 
effect be to increase brokers' demands on advisers to make payments out 
of their assets, i.e., revenue sharing? Are we correct in our 
assumption that properly disclosed revenue sharing payments present 
more manageable conflicts for funds and broker-dealers? \49\
---------------------------------------------------------------------------

    \49\ See Confirmation Requirements and Point of Sale Disclosure 
Requirements for Transactions in Certain Mutual Funds and Other 
Securities, and Other Confirmation Requirement Amendments, and 
Amendments to the Registration Form for Mutual Funds, Investment 
Company Act Release No. 26341 (Jan. 29, 2004) [69 FR 6438 (Feb. 10, 
2004)] (``Disclosure Requirements Release'').
---------------------------------------------------------------------------

     If our assumption is incorrect, should we take 
additional steps to address revenue sharing concerns? If so, what steps 
should we take?
    We also seek comment on whether we should propose instead that 
funds provide more complete disclosure to shareholders of the use of 
brokerage commissions to pay brokers for selling fund shares or 
otherwise modify or relocate the disclosures we currently require. 
Funds currently must disclose certain information relating to 
arrangements by which brokerage commissions are used to compensate 
broker-dealers for selling fund shares. A fund must disclose in the fee 
table in its prospectus the amounts paid pursuant to the 12b-1 plan, as 
a percentage of its average net assets.\50\ A fund also must describe 
in its statement of additional information (``SAI'') the material 
aspects of the fund's plan and any agreements related to the 
implementation of the plan, including the dollar amounts spent on 
specific kinds of distribution activities, including the compensation 
paid to selling broker-dealers.\51\ In addition, a fund's SAI must 
describe how the fund selects brokers to effect securities 
transactions, including a description of any factors the fund will 
consider in selecting brokers, and identification of the products or 
services the fund receives that it considers in making its 
selection.\52\ Rule 10b-10 under the Exchange Act, the general 
confirmation rule governing broker-dealers, requires disclosure 
regarding the source and extent of payments to broker-dealers in 
selling fund shares, including payments to broker-dealers in the form 
of portfolio brokerage commissions.\53\ Recently, we proposed rules 
requiring brokers to provide improved disclosure, at the point of sale 
and in mutual fund confirmation statements, of the receipt of brokerage 
commissions and revenue sharing payments in the sale of fund 
shares.\54\ We considered whether modifications to the disclosure 
requirements would adequately address the problems we describe above. 
Our concern with this approach, however, is that it may not be 
effective in preventing funds and fund shareholders from being harmed 
by the conflicts of interest that surround the use of fund brokerage to 
pay for distribution. In addition, the complicated nature of the 
various arrangements for using brokerage commissions may be difficult 
for investors to comprehend and to compare across different funds.
---------------------------------------------------------------------------

    \50\ Item 3 of Form N-1A requires all funds to provide a fee 
table that discloses, among other things, ``Distribution [and/or 
Service] (12b-1) Fees.'' This phrase is defined in instruction 3.b. 
to Item 3 as including ``all distribution or other expenses incurred 
during the most recent fiscal year under a plan adopted pursuant to 
rule 12b-1.'' The information must be based upon a fund's most 
recent fiscal year, but the information must be restated if there 
have been any changes that would materially affect the information 
that is disclosed in the table. Instructions 3.d.(i)-(ii) to Item 3 
of Form N-1A. Miscellaneous expenses paid through brokerage 
commissions must be reflected in the amount of expenses and expense 
ratio in a fund's statement of operations, which is part of its 
semi-annual and annual reports to shareholders and financial 
statements. See Investment Company Act Release No. 21221, supra note 
35, and rule 6.07(g) of Regulation S-X under the 1933 Act. In 
addition, a fund's brokerage commissions, including the portion that 
is used to pay for distribution, are reflected in the fund's net 
asset value, and are consequently reflected in the fund's 
performance calculations, regardless of whether the amounts are paid 
pursuant to a 12b-1 plan. See Items 2(c)(2) and 21 of Form N-1A.
    \51\ Item 15(g) of Form N-1A. This item also requires the fund 
to disclose (i) whether the fund participates in any joint 
distribution activities with another fund, and (ii) whether the 
fund's investment adviser (or any other interested person of the 
fund) has a direct or indirect interest in the financial operation 
of the 12b-1 plan or any related agreements. Id. In addition, a 
fund's statement of operations, must disclose the total dollar 
amounts that the fund paid under the 12b-1 plan. See rule 30d-1 
under the Investment Company Act (requiring certain information in a 
fund's semi-annual and annual reports to shareholders) and rule 6-
07(f) of Regulation S-X (requiring a fund's statement of operations 
to provide a statement of all amounts that were paid by the fund in 
accordance with a 12b-1 plan).
    \52\ Item 16(c) of Form N-1A. This disclosure is not as 
specific, however, as the disclosure required concerning research 
services a fund receives that factor into its selection of brokers. 
A fund that directs brokerage to a broker because of research 
services provided must state the amount of the transactions and 
related commissions. See item 16(d) of Form N-1A.
    \53\ See Disclosure Requirements Release, supra note 49, at text 
accompanying nn. 35 and 36.
    \54\ Proposed rule 15c2-2 under the Exchange Act would require 
confirmation statements for fund share purchases, among other 
disclosures, to state: (i) The amount of any dealer concession the 
broker-dealer will earn in connection with the transaction, 
expressed in dollars and as a percentage of the net amount invested; 
and (ii) the amount directly or indirectly earned by the broker-
dealer and any of its associated persons in connection with revenue 
sharing payments or brokerage commissions from the fund complex over 
the four most recent calendar quarters, expressed as a percentage of 
the total net asset value of the securities issued by the fund 
complex sold by the broker-dealer over that period. The rule also 
would require the confirmation to disclose the amount of revenue 
sharing or brokerage commissions the broker-dealer might receive in 
connection with the transaction, calculated by multiplying the 
percentage expressing the amount of revenue sharing or brokerage 
commission by the net amount invested in the transaction. See 
Disclosure Requirements Release, supra note 49. Proposed rule 15c-3 
would require brokers, dealers, and municipal securities dealers to 
provide specific information to investors at the point of sale (or 
before they purchase fund shares), including (i) an estimate of the 
asset-based sales charge and service fee that, in the year following 
the purchase, the fund would incur in connection with the shares 
purchased if net asset value does not change, and (ii) whether the 
selling broker, dealer, or municipal securities dealer receives 
brokerage commissions from the fund complex. See id.
---------------------------------------------------------------------------

     Should we increase or revise the disclosure 
requirements concerning the use of brokerage commissions to pay brokers 
for selling fund shares? Instead of banning directed brokerage, is 
there a disclosure-based alternative that would adequately address the 
concerns discussed above. If so, what should be the format of these 
disclosures? Where should these disclosures be located--in the 
prospectus, the SAI, or the annual reports?
     Should the disclosures be quantitative (e.g., 
discuss the amount of brokerage commissions) or qualitative (e.g., 
discuss the nature of the arrangements and the potential conflicts of 
interest), or both? Could a single quantitative measure accurately 
disclose the costs under the many different arrangements through which 
brokerage commissions are used to pay for distribution?
     Would the disclosures enable shareholders, 
either directly or based on

[[Page 9731]]

assessments by investment analysts, to choose between funds that engage 
in these types of arrangements?
     What costs would a fund likely incur in making 
these disclosures?
     Should we revise the disclosure requirements and 
ban the use of brokerage commissions in the manner described above? 
Should we revise the disclosure requirements and ban only certain types 
of arrangements under which brokerage commissions are used to finance 
distribution?

B. Policies and Procedures

    We are also proposing to require that any fund (or its adviser) 
that directs any portfolio securities transactions to a selling broker-
dealer implement policies and procedures designed to ensure that its 
selection of brokers to effect portfolio securities transactions is not 
influenced by considerations about the sale of fund shares.\55\ These 
procedures must be reasonably designed to prevent: (i) The persons 
responsible for selecting broker-dealers to effect transactions in fund 
portfolio securities (e.g., trading desk personnel) from taking broker-
dealers' promotional or sales efforts into account in making those 
decisions;\56\ and (ii) the fund, its adviser or principal underwriter, 
from entering into any agreement under which the fund directs brokerage 
transactions or revenue generated by those transactions to a broker-
dealer to pay for distribution of the fund's shares.\57\ The fund's 
board of directors, including a majority of its independent directors, 
must approve the policies and procedures.\58\
---------------------------------------------------------------------------

    \55\ Proposed rule 12b-1(i). As with all other portfolio 
securities transactions, the fund's adviser has a fiduciary duty to 
seek best execution. The adviser must see that these portfolio 
securities transactions are executed ``in such a manner that the 
client's total cost or proceeds in each transaction is most 
favorable under the circumstances.'' In re Kidder, Peabody & Co., 
Inc., Investment Advisers Act Release No. 232 (Oct. 16, 1968). See 
also Section 28(e) Interpretive Release, supra note 17; 
Applicability of the Commission's Policy Statement on the Future 
Structure of the Securities Markets to Selection of Brokers and 
Payment of Commissions by Institutional Managers, Investment Company 
Act Release No. 7170, [1971-72 Transfer Binder] Fed. Sec. L. Rep. 
(CCH) 78,776 (May 17,1972) (advisers ``must assign executions and 
pay for brokerage services in accordance with the reliability and 
quality of those services and their value and expected contribution 
to the performance of the account they are managing'').
    \56\ Proposed rule 12b-1(i)(1).
    \57\ Proposed rule 12b-1(i)(2). The policies and procedures 
should be designed to reach any arrangement or other understanding, 
whether binding or not, between a fund and a broker-dealer, 
including an understanding to direct brokerage to a government 
securities broker or dealer or a municipal securities dealer.
    \58\ Proposed rule 12b-1(i).
---------------------------------------------------------------------------

    The policies and procedures that the rule would require are more 
specific than those we recently required all funds and investment 
advisers to adopt.\59\ The proposed requirement is designed to ensure 
the active monitoring of brokerage allocation decisions when executing 
brokers also distribute the fund's shares.
---------------------------------------------------------------------------

    \59\ See Compliance Programs of Investment Companies and 
Investment Advisers, Investment Company Act Release No. 26299 (Dec. 
17, 2003) [68 FR 74714 (Dec. 24, 2003)].
---------------------------------------------------------------------------

     Is it appropriate to require funds that execute 
transactions through their selling brokers to implement policies and 
procedures to ensure that distribution considerations do not affect 
execution decisions?
     Is the scope of the proposed policies and 
procedures appropriate? Should we include different or additional 
objectives?
     Would these policies and procedures be effective 
in preventing funds and broker-dealers from circumventing the ban on 
paying distribution-related expenses with brokerage commissions?
     Should we adopt other measures to help the fund 
monitor the use of fund brokerage? The rule would require the board of 
directors to approve the policies and procedures. Should we also 
require the board of directors to monitor the fund's adherence to the 
policies and procedures, or to approve the allocation of brokerage? 
Should we require the fund's adviser to report to the board on its 
decisions regarding brokerage allocation? Are there other measures we 
should require the board to take to ensure that brokerage decisions are 
not influenced by brokers' distribution efforts?
     Should we require a fund's chief trading officer 
(or another official of the fund or its adviser) to certify 
periodically that the selection of brokers to execute the fund's 
portfolio securities transactions was made without taking into account 
the brokers' promotion or sale of shares issued by the fund or any 
other fund?
     Should we include a safe harbor in the rule for 
funds that execute portfolio securities transactions with a selling 
broker? If so, what conditions should we include in the safe harbor? 
Would the absence of a safe harbor affect the ability of funds to 
obtain best execution?

III. General Request for Comment

    We request comment on the proposed rule amendments described above, 
including suggestions for additional provisions or changes, and 
comments on other matters that might have an effect on the proposal. We 
encourage commenters to provide data to support their views.

IV. Request for Comment on Further Amendments to Rule 12b-1

    We also request comment on whether we should propose additional 
changes to rule 12b-1 to address other issues that have arisen under 
the rule, or propose to rescind the rule.\60\ As our staff has noted, 
the current practice of using 12b-1 fees as a substitute for a sales 
load is a substantial departure from the use of the rule envisioned by 
the Commission when we adopted the rule in 1980.\61\ As a result, its 
provisions may not address a number of matters that today face funds 
and fund shareholders.\62\ The comments we receive will help us 
consider whether to propose further amendments.
---------------------------------------------------------------------------

    \60\ When we adopted the rule, we noted: ``The Commission and 
its staff will monitor the operation of the rules closely and will 
be prepared to adjust the rules in light of experience to make the 
restrictions on use of fund assets for distribution either more or 
less strict.'' See 1980 Adopting Release, supra note 21.
    \61\ Division of Investment Management, SEC, Report on Mutual 
Fund Fees and Expenses 81 (2000) (``Staff Fee Report''). See also 
William P. Dukes and James B. Wilcox, The Difference Between 
Application and Interpretation of the Law as it Applies to SEC Rule 
12b-1 Under the Investment Company Act of 1940, 27 New Eng. L. Rev. 
9 (1992).
    \62\ We have, however, responded to the evolution of rule 12b-1 
plans in a number of ways, including, for example, approving NASD 
rules capping the amount of fund distribution expenses (see supra 
notes 22 through 26, and accompanying text), and adopting a rule 
permitting multiple classes of shares. See rule 18f-3 under the 
Investment Company Act [17 CFR 270.18f-3]. See also Exemption for 
Open-End Management Investment Companies Issuing Multiple Classes of 
Shares; Disclosure by Multiple Class and Master-Feeder Funds; Class 
Voting on Distribution Plan, Investment Company Act Release No. 
20915 (Feb. 23, 1995) [60 FR 11876 (Mar. 2, 1995)]. In 2000, our 
staff recommended that we revisit rule 12b-1 in light of ``changes 
in the manner in which funds are marketed and distributed and the 
experience gained from observing how rule 12b-1 has operated since 
it was adopted in 1980.'' Staff Fee Report, supra note 61. More 
recently, the staff has stated that it will continue to assess the 
issues raised by rule 12b-1 in light of the recommendations in the 
Staff Fee Report and changes in distribution practices since the 
rule's adoption. See Memorandum from Paul F. Roye, Director, SEC 
Division of Investment Management, to William H. Donaldson, 
Chairman, SEC (June 9, 2003) (http://financialservices. house.gov/media/pdf/02-14-70%20memo.pdf). Former Chairman Pitt called for a 
reexamination of distribution practices. Harvey L. Pitt, Chairman, 
SEC, Speech to the Investment Company Institute General Membership 
Meeting (May 24, 2002). See also Brooke A. Masters, Counting the 
Costs of Fund Fees; Investigators' Attention Turns to Legal, 
Lucrative ``Advertising'' Charges, Washington Post, Dec. 4, 2003, at 
E1; Craig A. Rubinstein, Excessive Mutual Fund Advisory Fees: Give-
Ups in Rule 12b-1 Clothing?, 14 Ann. Rev. Banking L. 385, 404 (1995) 
(recommending that we consider repealing rule 12b-1).
---------------------------------------------------------------------------

    One approach on which we would particularly like to receive comment 
would refashion rule 12b-1 to provide that funds deduct distribution-
related costs directly from shareholder accounts rather than from fund 
assets. Under this

[[Page 9732]]

approach, a shareholder purchasing $10,000 of fund shares with a five 
percent sales load could pay a $500 sales load at the time of purchase, 
or could pay an amount equal to some percentage of the value of his or 
her account each month until the $500 amount is fully paid (plus 
carrying interest).\63\ If the shareholder redeemed before the amount 
was fully paid, the proceeds of the redemption would be reduced by the 
unpaid amount.\64\ As with other sales charges, the account-based fees 
would be subject to NASD caps.\65\
---------------------------------------------------------------------------

    \63\ In choosing between paying a front-end load or spreading 
the payment of the load over time, a shareholder would have to take 
into consideration, among other factors, the possibility that 
payment of loads through periodic automatic redemptions (to the 
extent that the loads exceed distributions) may result in the 
shareholder realizing capital gains or losses.
    \64\ Funds today may charge account-based distribution fees. See 
rule 6c-10 under the Investment Company Act, and Exemption for 
Certain Open-end Management Investment Companies to Impose Deferred 
Sales Loads, Investment Company Act Release No. 22202 (Sept. 9, 
1996) [61 FR 49011 (Sept. 17, 1996)] (referring to these 
distribution arrangements as ``installment loads'').
    \65\ See supra notes through and accompanying text.
---------------------------------------------------------------------------

    This approach may have a number of advantages compared to current 
arrangements under which the fund pays fees pursuant to a rule 12b-1 
plan approved by shareholders and overseen by fund directors. First, 
the amounts charged and their effect on shareholder value would be 
completely transparent to the shareholder because the amounts will 
appear on the shareholder's account statements. Second, existing 
shareholders would not pay the costs of selling to new fund 
shareholders'costs that often may yield them few benefits. Third, long-
term shareholders would no longer, as a result of paying a share of 
12b-1 fees over a lengthy period, pay amounts that exceed their fair 
share of distribution costs.\66\
---------------------------------------------------------------------------

    \66\ Although classes of shares carrying rule 12b-1 fees may be 
structured to convert to classes without rule 12b-1 fees, those 
conversions typically do not occur for a substantial period of time, 
e.g., ten years.
---------------------------------------------------------------------------

    A shareholder account-based approach to distribution payments would 
help to eliminate the substantial conflicts of interest presented by 
the use of fund assets to pay for distribution. As a result, the role 
of fund directors in approving methods of distribution could be 
eliminated (or substantially circumscribed), freeing their time to 
address other significant matters. Rule 12b-1's shareholder voting 
requirements could be eliminated, reducing fund expenses. The detailed 
regulatory requirements of rule 12b-1 and NASD rule 2830(d) designed to 
address these conflicts could be substantially reduced or eliminated, 
reducing related legal and compliance costs that fund shareholders have 
ultimately born.\67\
---------------------------------------------------------------------------

    \67\ Fund distributors could also benefit. Unlike rule 12b-1 
fees, which are subject to annual renewal by fund directors, an 
account-based distribution fee could provide a dependable and 
legally certain flow of payments, that are unaffected by any 
shrinkage in fund assets. See John Shipman, B-ware: Shares with 
Back-End Loads Can Sting Investors and Fund Companies, Barron's, 
Jan. 6, 2003, at L10 (``[N]ow that the bear market has battered many 
portfolios, 12b-1 and back-end fees are being drawn from a shrinking 
base of assets, producing lower-than-expected cash flows.''); Tom 
Leswing, Munder B Share Sales Continue to Sting Parent, Ignites.com, 
Oct. 17, 2002 (http://www.ignites.com/) (reporting Comerica's $5 
million charge against third-quarter revenues as a result of a 
decline in its subsidiary's revenue from 12b-1 fees corresponding to 
a decline in assets under management).
---------------------------------------------------------------------------

    A shareholder account-based approach to distribution payments also 
could simplify investing in funds and eliminate many of the problems 
with fund sales practices we see today. Funds would no longer need to 
have separate classes of shares based on rule 12b-1 fees, which many 
shareholders have found very confusing.\68\ Fund prospectuses would be 
shorter and more understandable. Sales practice abuses associated with 
the existence of separate classes could also be eliminated.\69\
---------------------------------------------------------------------------

    \68\ See, e.g., Timothy Middleton, Abecedarians, Take Note: 
Classes Multiply, N. Y. Times, Nov. 26, 1996, at 8 (``Fund companies 
have shown great ingenuity in creating share classes that, while 
legal, may leave buyers baffled.''); Andrew Leckey, Understanding 
Shares Isn't As Easy As ABC, Chi. Trib., Aug. 7, 2001, at 7 
(``Mutual fund share classes have become a confusing alphabet soup 
for investors who put money into so-called ``load'' mutual funds 
that require a sales charge.''). See also Gregg Greenberg, Mutual 
Fund Class Warfare, TheStreet.com, Dec. 3, 2003 (http://www.thestreet. com/funds/gregggreenberg/10129505.html).
    \69\ Recently, we have instituted a number of actions against 
firms and registered representatives for selling Class B shares, 
which generated higher commissions than class A shares, to clients 
for whom Class A shares were more suitable. See, e.g., In re 
Prudential Securities, Inc., Exchange Act Release No. 48149 (July 
10, 2003); In re Morgan Stanley DW Inc., Exchange Act Release No. 
48789 (Nov. 17, 2003); In re Kissinger, Exchange Act Release No. 
48178 (July 15, 2003). The NASD also has instituted actions for 
Class B sales practice abuses. See, e.g., NASD Brings Enforcement 
Action for Class B Mutual Fund Share Sales Abuses and Issues 
Investor Alert on Class B Shares, NASD News Release, June 25, 2003 
(``Today's action is part of a larger, ongoing focus of NASD on the 
sale of Class B mutual fund shares. In the last two years NASD has 
brought more than a half dozen significant enforcement cases 
involving sales violations of Class B shares.'').
---------------------------------------------------------------------------

     We request comment on these ideas, particularly 
from shareholders who pay 12b-1 fees and fund directors who are charged 
with supervising funds' 12b-1 plans. Would a shareholder account-based 
approach make sense?
    Some have suggested that, instead of modifying rule 12b-1, we 
should rescind the rule.\70\
---------------------------------------------------------------------------

    \70\ See, e.g., Neil Weinberg, Let the Sun Shine, Forbes, Dec. 
22, 2003, at 72; Rubinstein Article, supra note 62.
---------------------------------------------------------------------------

    Critics of the rule often argue that it no longer serves the 
purposes for which it was intended.\71\ Others contend that rescinding 
the rule would harm funds and fund shareholders.\72\ We request comment 
on whether we should propose to rescind the rule.
---------------------------------------------------------------------------

    \71\ See, e.g., Oversight Hearing on Mutual Funds: Hidden Fees, 
Misgovernance and Other Practices that Harm Investors, Hearings 
Before the Subcommittee on Financial Management, the Budget, and 
International Security of the Senate Committee on Governmental 
Affairs 108th Cong., 2d Sess. (Jan. 27, 2004) (statement of Travis 
B. Plunkett, Legislative Director, Consumer Federation of America).
    \72\ See, e.g., Masters, Counting the Costs of Fund Fees, supra 
note (``Mutual fund company officials defend 12b-1 fees, saying the 
charge has opened up a wider range of investment options for the 
more than 60 percent of mutual fund investors who buy through 
brokers.''); Stephen Schurr, False Advertising; The Truth About 12b-
1 Fees, TheStreet.com, Aug. 31, 2003 (http://www.thestreet.com/--
tscs/funds/stephenschurr/10107579.html) (``[T]o the Investment 
Company Institute, which represents the fund industry, 12b-1 fees 
serve a vital function to individuals and have actually helped drive 
fund expenses down over the past 20 years.'').
---------------------------------------------------------------------------

     If we were to rescind the rule, what would be 
the consequences for funds, fund shareholders, fund advisers, and 
brokers that sell fund shares? How would elimination of the rule affect 
the aggregate amount of shareholder expenses? What alternate methods of 
financing distribution would funds and advisers use?
     Should the fund's adviser or principal 
underwriter pay all promotional expenses, or are there certain 
distribution expenses that should be paid with fund assets?
     Funds often pay for administrative services 
provided by third parties with asset-based fees.\73\ If we were to 
propose to rescind rule 12b-1, should we also propose restrictions on 
the use of asset-based fees to ensure that distribution expenses are 
not improperly characterized as, e.g., shareholder account servicing 
expenses?
---------------------------------------------------------------------------

    \73\ See, e.g., Investment Company Institute, Use of Rule 12b-1 
Fees by Mutual Funds in 1999, Fundamentals, Apr. 2000, at 2 (Figure 
2) (http://www.ici.org/stats/res/fm-v9n1.pdf) (finding, based on a 
survey of 95 fund complexes, that 32% of 12b-1 fees are used to pay 
for administrative services). In addition to imposing asset-based 
sales charges, NASD rules permit an asset-based ``service fee'' of 
up to 0.25% to cover ``payments by an investment company for 
personal service and/or the maintenance of shareholder accounts.'' 
NASD Conduct Rules 2830(b)(9) (defining ``Service fees'') and 
2830(d)(5) (prohibiting NASD members from selling a fund if its 
service fee, as disclosed in its prospectus, exceeds 0.25%).
---------------------------------------------------------------------------

     If we were to rescind rule 12b-1, would 
particular types of funds, such as

[[Page 9733]]

funds with fewer net assets or newer funds, be disproportionately 
disadvantaged?
     How would rescission of rule 12b-1 affect 
distribution arrangements, e.g., fund supermarkets and other 
arrangements that anticipate the receipt of 12b-1 fees?
     If we rescind the rule, should we propose a new 
rule that would prohibit the use of fund assets to pay for sales and 
distribution expenses?

V. Cost-Benefit Analysis

    We are sensitive to the costs and benefits that result from our 
rules. The proposed amendments would prohibit the use of brokerage 
commissions to compensate broker-dealers for the distribution of fund 
shares. We encourage commenters to identify, discuss, analyze, and 
supply relevant data regarding these or any additional costs and 
benefits.

A. Benefits

    The proposed amendments would benefit funds and their shareholders. 
An increasing number of funds are using a limited number of 
distribution channels, and the broker-dealers who control these 
channels routinely demand supplemental payments (in addition to the 
compensation they receive in the form of sales charges) for access to 
that distribution network. We have found that one form of supplemental 
compensation comes from directed brokerage arrangements, pursuant to 
which fund advisers direct brokerage commissions from fund portfolio 
securities transactions to selling brokers. A prohibition on using 
directed brokerage to pay for distribution would reduce the ability of 
selling brokers to demand supplemental distribution payments, and may 
reduce commission rates that funds pay to the extent that these 
payments would be excluded from the commission rate.
    Fund brokerage is a valuable fund asset and thus should be used in 
the manner that most benefits the fund and its shareholders. Using 
excess brokerage commissions to finance distribution currently imposes 
a cost on funds, because those brokerage commissions are unavailable to 
pay for other services for the fund. Because this cost is difficult to 
quantify, however, fund shareholders may not realize the true cost of 
financing distribution in this manner. The difficulty of quantifying 
the cost to the fund of brokerage financing makes the conflicts of 
interest accompanying the direction of fund brokerage particularly 
acute. Our staff's recent review of directed brokerage practices has 
raised questions about whether fund advisers and broker-dealers, rather 
than funds and fund shareholders, are the beneficiaries of these 
arrangements.
    The proposed amendments, by prohibiting the practice of directing 
brokerage for distribution, would address this conflict of interest. 
The proposal would benefit fund shareholders by prohibiting the adviser 
from considering distribution as a factor in selecting an executing 
broker. Funds would be able to use the entire amount of the brokerage 
commission to purchase execution and other services of direct benefit 
to funds and their shareholders. By removing distribution as a factor 
in the selection of selling brokers, the proposed amendments will 
enhance the likelihood that advisers will select brokers based on the 
quality and cost of execution.

B. Costs

    The proposed amendments might decrease the commissions received by 
broker-dealers and might impose new costs on investment advisers and 
funds. The elimination of brokerage commissions as a source of 
distribution financing could reduce the amount of compensation that 
broker-dealers receive for selling fund shares and could dissuade them 
from selling fund shares. Selling brokers are likely to seek to make up 
for any shortfall from other sources. To the extent that distribution 
fees do not currently exceed the NASD's caps, funds may institute or 
increase fees deducted from fund assets under a rule 12b-1 plan. 
Alternatively, advisers may increase the payments that they make to 
broker-dealers out of their own assets, which are likely to cause 
advisers' costs to rise.
    We assume that a great majority of, if not all, funds are likely to 
find that, for some portfolio transactions, the broker-dealer who can 
provide best execution also distributes the fund's shares. Thus, we 
assume that all funds will incur costs in order to comply with the 
requirement for policies and procedures contained in the proposed 
amendments. Specifically, they or their advisers would be required to 
institute policies and procedures reasonably designed to prevent: (i) 
The persons responsible for selecting broker-dealers to effect 
transactions in fund portfolio securities (e.g., trading desk 
personnel) from taking broker-dealers' promotional or sales efforts 
into account in making those decisions; and (ii) the fund, its adviser 
or principal underwriter, from entering into any agreement under which 
the fund directs brokerage transactions or revenue generated by those 
transactions to a broker-dealer to pay for distribution of the fund's 
shares. We do not anticipate that drafting or implementing these 
policies and procedures will be costly.
    By narrowing the options for financing distribution of fund shares, 
the proposed amendments could impose costs on funds and their advisers. 
If the remaining methods of financing distribution are not adequate, 
funds may not grow as quickly as they otherwise would have. Advisers, 
whose compensation is generally tied to net assets, may experience 
slower growth in their advisory fees, and fund shareholders may not 
benefit from the economies of scale that accompany asset growth.\74\
---------------------------------------------------------------------------

    \74\ Historically, however, fund shareholders have not always 
enjoyed lower expenses as a result of increased assets.
---------------------------------------------------------------------------

C. Request for Comment

    We request comment on the potential costs and benefits identified 
in the proposal and any other costs and benefits that may result from 
the proposed amendments. For purposes of the Small Business Regulatory 
Enforcement Fairness Act of 1996, the Commission also requests 
information regarding the impact of the proposed rule on the economy on 
an annual basis. Commenters are requested to provide data to support 
their views.

VI. Consideration of Promotion of Efficiency, Competition, and Capital 
Formation

    Section 2(c) of the Investment Company Act mandates the Commission, 
when engaging in rulemaking that requires it to consider or determine 
whether an action is necessary or appropriate in the public interest, 
to consider, in addition to the protection of investors, whether the 
action will promote efficiency, competition, and capital formation.\75\
---------------------------------------------------------------------------

    \75\ 15 U.S.C. 80a-2(c).
---------------------------------------------------------------------------

    As discussed above, the proposed amendments would prohibit funds 
from compensating selling brokers with commissions generated from fund 
portfolio securities transactions. This new prohibition could promote 
efficiency by eliminating brokers' selling efforts, which are not 
indicative of their execution capabilities, as a factor that fund 
advisers use in selecting an executing broker. Efficiency also would be 
enhanced because, if commissions are not used to finance the 
distribution of a fund's shares, lower commission rates may be 
available or the fund may be able to obtain other services more 
directly beneficial to it and its shareholders.

[[Page 9734]]

    We do not anticipate that these proposed amendments would harm 
competition. All funds would be precluded from using this form of 
compensation. In addition, the amendments should reduce incentives that 
broker-dealers currently have to base their fund recommendations to 
customers on payment for distribution. The amendments also could foster 
greater competition in brokerage commission rates by unbundling 
distribution from execution. Thus, the proposed amendments are designed 
to enhance competition.
    The proposed amendments would prohibit a fund from relying on its 
selling brokers to effect fund portfolio securities transactions unless 
the fund has policies and procedures in place designed to ensure the 
active monitoring of brokerage allocation decisions when executing 
brokers also distribute the fund's shares. Thus, funds would not be 
unnecessarily limited in their choice of executing brokers, and the 
proposed amendments would not have adverse effects on competition in 
the provision of brokerage services. We do not anticipate that the 
proposed amendments would affect capital formation.
    We request comment on whether the proposed amendments will affect 
efficiency, competition, or capital formation. Would the proposed 
amendments materially affect the efficiency, competition, and capital 
formation of funds, advisers, or broker-dealers? Comments will be 
considered by the Commission in satisfying its responsibilities under 
section 2(c) of the Investment Company Act. Commenters are requested to 
provide empirical data and other factual support for their views to the 
extent possible.

VII. Paperwork Reduction Act

    The proposed amendments contain a ``collection of information'' 
requirement within the meaning of the Paperwork Reduction Act of 
1995.\76\ We are submitting this proposal to the Office of Management 
and Budget (``OMB'') for review in accordance with 44 U.S.C. 3507(d) 
and 5 CFR 1320.11. The proposed amendments would add ``collection of 
information requirements'' to the existing collection of information 
requirements under rule 12b-1 of the Investment Company Act of 1940. 
The title for the collection of information requirements associated 
with the proposed amendments is ``Rule 12b-1 under the Investment 
Company Act, `Distribution of Shares by Registered Open-End Management 
Investment Company.' '' An agency may not conduct or sponsor, and a 
person is not required to respond to, a collection of information 
unless it displays a currently valid control number. The approved 
collection of information associated with rule 12b-1, which would be 
revised by the proposed amendments, displays OMB control number 3235-
0212.
---------------------------------------------------------------------------

    \76\ 44 U.S.C. 3501 to 3520.
---------------------------------------------------------------------------

    Rule 12b-1 permits funds to use their assets to pay distribution-
related costs. In order to rely on rule 12b-1, a fund must adopt ``a 
written plan describing all material aspects of the proposed financing 
of distribution'' that is approved by fund shareholders and fund 
directors. Any material amendments to the rule 12b-1 plan similarly 
must be approved by fund directors, and any material increase in the 
amount to be spent under the plan must be approved by fund 
shareholders. In considering a rule 12b-1 plan, the fund board must 
request and evaluate information reasonably necessary to make an 
informed decision. Rule 12b-1 also requires the fund to preserve for 
six years copies of the plan, any related agreements and reports, as 
well as minutes of board meetings that describe the factors considered 
and the basis for implementing or continuing a rule 12b-1 plan.
    To eliminate a practice that is fraught with conflicts of interest 
and may be harmful to funds and fund shareholders, we propose to amend 
rule 12b-1 to prohibit funds from paying for the distribution of their 
shares with brokerage commissions. The proposed amendments would 
require funds that use their selling brokers to execute securities 
transactions to implement, and their boards of directors (including a 
majority of independent directors) to approve, policies and procedures. 
The policies and procedures would have to be reasonably designed to 
prevent: (i) The persons responsible for selecting broker-dealers to 
effect transactions in fund portfolio securities from taking broker-
dealers' promotional or sales efforts into account in making those 
decisions; and (ii) the fund, its adviser or principal underwriter, 
from entering into any agreement under which the fund directs brokerage 
transactions or revenue generated by those transactions to a broker-
dealer to pay for distribution of the fund's shares. This requirement 
includes the following new information collections: (i) A fund's 
documentation of its policies and procedures, and (ii) the approval by 
the board of directors of those policies and procedures.
    The new information collection requirements would be mandatory. 
Responses provided to the Commission in the context of its examination 
and oversight program are generally kept confidential.\77\
---------------------------------------------------------------------------

    \77\ See section 31(c) of the Investment Company Act [15 U.S.C. 
80a-30(c)].
---------------------------------------------------------------------------

    The current annual information collection burden for rule 12b-1 is 
621,700 hours. We estimate that, if the proposed amendments are 
adopted, the burden will increase to 628,833 hours. Our staff estimates 
that there are approximately 6,185 mutual fund portfolios with rule 
12b-1 plans.\78\ We anticipate that, if the proposed amendments are 
adopted, all of the approximately 3,100 active open-end funds will 
implement the policies and procedures required to use their selling 
brokers to execute portfolio securities transactions.\79\
---------------------------------------------------------------------------

    \78\ This estimate, which is based on information filed with the 
Commission by funds, reflects an adjustment from our previous 
estimate of 6,217.
    \79\ We have estimated the information collection burdens 
associated with the policies and procedures required by the proposed 
amendments at the fund level, rather than the fund portfolio level, 
because we anticipate that one set of policies and procedures will 
cover a fund consisting of multiple portfolios.
---------------------------------------------------------------------------

    Based on conversations with fund representatives, Commission staff 
estimates that for each of the 6,185 mutual fund portfolios that 
currently have a rule 12b-1 plan, the average annual burden of 
complying with the rule is 100 hours to maintain the plan and the total 
burden hours per year for all fund portfolios is 618,500 hours.\80\ In 
the first year after adoption of the proposed amendments, we estimate 
that each fund will spend 10 hours to comply with the new information 
collection requirement, for a total of 31,000 additional burden hours 
in the first year.\81\ The aggregate burden for all funds in the first 
year after adoption, therefore, is estimated to be 649,500 hours.\82\ 
We estimate that the average weighted annual burden for all funds over 
the three-year period for which we are requesting approval of the 
information collection burden will be approximately 628,833 hours.\83\
---------------------------------------------------------------------------

    \80\ 6,185 fund portfolios x 100 hours per fund portfolio = 
618,500 hours. This estimate takes into account the time needed to 
prepare quarterly reports to the board of directors, the board's 
consideration of those reports, and the board's annual consideration 
of the plan's continuation.
    \81\ 3,100 funds x 10 hours per fund = 31,000 hours.
    \82\ 618,500 hours to comply with existing requirements + 31,000 
hours to comply with the new requirements = 649,500.
    \83\ 649,500 hours in year 1 + 618,500 hours in year 2 + 618,500 
hours in year 3/3 years = 628,833 hours/year.
---------------------------------------------------------------------------

    If a currently operating fund seeks to adopt a new rule 12b-1 plan 
or materially increase the amount it spends for distribution under its 
rule 12b-1

[[Page 9735]]

plan, existing rule 12b-1 requires that the fund obtain shareholder 
approval. As a consequence, the fund will incur the cost of a proxy. 
Based on conversations with fund representatives, Commission staff 
estimates that three funds per year prepare a proxy in connection with 
the adoption or material amendment of a rule 12b-1 plan. We do not 
anticipate that the proposed amendments would result in an increase in 
the number of proxies prepared. The staff further estimates that the 
cost of each fund's proxy is $30,000.\84\ Thus, the total aggregate 
annual cost burden of rule 12b-1 for funds is $90,000.
---------------------------------------------------------------------------

    \84\ This estimate, which is based on staff conversations with 
representatives of funds, reflects an adjustment from our previous 
estimate of $15,000 per proxy.
---------------------------------------------------------------------------

    We request comment on whether these estimates are reasonable. 
Pursuant to 44 U.S.C. 3506(c)(2)(B), we solicit comments in order to: 
(i) Evaluate whether the proposed collections of information are 
necessary for the proper performance of the functions of the 
Commission, including whether the information will have practical 
utility; (ii) evaluate the accuracy of the Commission's estimate of the 
burden of the proposed collections of information; (iii) determine 
whether there are ways to enhance the quality, utility, and clarity of 
the information to be collected; and (iv) minimize the burden of the 
collections of information on those who respond, including through the 
use of automated collection techniques or other forms of information 
technology.
    Persons wishing to submit comments on the collection of information 
requirements of the proposed amendments should direct them to the 
Office of Management and Budget, Attention Desk Officer of the 
Securities and Exchange Commission, Office of Information and 
Regulatory Affairs, Room 10102, New Executive Office Building, 
Washington, DC 20503, and should send a copy to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609, with reference to File No. S7-09-04. OMB is 
required to make a decision concerning the collection of information 
between 30 and 60 days after publication of this Release; therefore a 
comment to OMB is best assured of having its full effect if OMB 
receives it within 30 days after publication of this Release. Requests 
for materials submitted to OMB by the Commission with regard to this 
collection of information should be in writing, refer to File No. S7-
09-04, and be submitted to the Securities and Exchange Commission, 
Records Management, Office of Filings and Information Services.

VIII. Initial Regulatory Flexibility Analysis

    This Initial Regulatory Flexibility Analysis (``IRFA'') has been 
prepared in accordance with 5 U.S.C. 603. It relates to the proposed 
amendments to rule 12b-1, which governs the use of fund assets to 
finance the distribution of fund shares.

A. Reasons for the Proposed Action

    As described more fully in Section I of this Release, the proposed 
amendments are necessary to address the practice of directing brokerage 
commissions to particular broker-dealers in order to compensate them 
for selling fund shares, a practice we believe is fraught with 
conflicts of interests and may be harmful to funds and fund 
shareholders.

B. Objectives of the Proposed Action

    As described more fully in Section II of this Release, the 
objectives of the proposed amendments, which would apply to all funds, 
are to prohibit funds from paying for distribution of fund shares with 
brokerage commissions and to ensure the active monitoring of brokerage 
allocation decisions when executing brokers also distribute the fund's 
shares.

C. Legal Basis

    The amendments to rule 12b-1 are being proposed pursuant to the 
authority set forth in sections 12(b) [15 U.S.C. 80a-12(b)] and 38(a) 
[15 U.S.C. 80a-37(a)] of the Investment Company Act.

D. Small Entities Subject to the Rule and Proposed Amendments

    A small business or small organization (collectively, ``small 
entity''), for purposes of the Regulatory Flexibility Act, is a fund 
that, together with other funds in the same group of related investment 
companies, has net assets of $50 million or less as of the end of its 
most recent fiscal year.\85\ Of approximately 5,124 registered 
investment companies, approximately 204 are small entities.\86\ As 
discussed above, the proposed amendments would prohibit all funds, 
regardless of size, from using portfolio brokerage commissions to 
finance distribution. All funds that use selling brokers to execute 
portfolio transactions would be required to implement policies and 
procedures. We have no reason to expect that small entities would be 
disproportionately affected by the proposed amendments. We request 
comment on the effects and costs of the proposed amendments on small 
entities.
---------------------------------------------------------------------------

    \85\ 17 CFR 270.0-10.
    \86\ Some or all of these entities may contain multiple series 
or portfolios. If a registered investment company is a small entity, 
the portfolios or series it contains are also small entities.
---------------------------------------------------------------------------

E. Reporting, Recordkeeping, and Other Compliance Requirements

    The proposed amendments do not include any new reporting or 
recordkeeping requirements. The proposed amendments would introduce a 
new prohibition, applicable to all funds, including small entities, on 
the use of fund brokerage commissions to compensate selling brokers. In 
addition, all funds, including small entities, would be prohibited from 
using selling brokers to execute portfolio transactions unless they 
have implemented policies and procedures reasonably designed to 
prevent: (i) the persons responsible for selecting broker-dealers to 
effect transactions in fund portfolio securities from taking broker-
dealers' promotional or sales efforts into account in making those 
decisions; and (ii) the fund, its adviser or principal underwriter, 
from entering into any agreement under which the fund directs brokerage 
transactions or revenue generated by those transactions to a broker-
dealer to pay for distribution of the fund's shares. The board of 
directors would have to approve these policies and procedures.

F. Duplicative, Overlapping, or Conflicting Federal Rules

    We have not identified any federal rules that duplicate, overlap, 
or conflict with the proposed amendments. The requirement that funds 
that use their selling brokers to execute portfolio securities 
transactions implement policies and procedures is encompassed by the 
more general requirement for compliance policies and procedures 
contained in rule 38a-1 under the Investment Company Act.\87\ The 
policies and procedures that the proposed amendments would require are 
more specific than those we recently required all funds and investment 
advisers to adopt and are designed to ensure the active monitoring of 
brokerage allocation decisions when a fund's executing brokers also 
distribute the fund's shares. If a fund has implemented policies and 
procedures under the proposed amendments, it would be able to 
incorporate those policies and procedures into the

[[Page 9736]]

policies and procedures it maintains pursuant to rule 38a-1.
---------------------------------------------------------------------------

    \87\ 17 CFR 270.38a-1.
---------------------------------------------------------------------------

G. Significant Alternatives

    The Regulatory Flexibility Act directs us to consider significant 
alternatives that would accomplish the stated objective, while 
minimizing any significant adverse impact on small entities. 
Alternatives in this category would include: (i) Establishing different 
compliance or reporting standards that take into account the resources 
available to small entities; (ii) clarifying, consolidating, or 
simplifying the compliance requirements under the rule for small 
entities; (iii) using performance rather than design standards; and 
(iv) exempting small entities from coverage of the rule, or any part of 
the rule.
    Establishing different standards for small entities is not feasible 
because we believe that a complete ban on the use of brokerage 
commissions to finance distribution is necessary in light of the 
intensity of the conflicts of interest that surround the practice. It 
would be inappropriate to apply a different standard for small 
entities, whose advisers may face even greater pressure than advisers 
to larger funds to take all measures to enhance distribution. 
Shareholders of small funds should receive the same protection as 
shareholders in large funds. Nevertheless, we request comment on 
whether we should modify the proposed amendments in any way to reduce 
the burden on small entities.
    We do not believe that clarification, consolidation, or 
simplification of the compliance requirements is feasible. The proposed 
amendments contain a straightforward ban on the use of brokerage 
commissions to finance distribution. The special requirements 
applicable to a fund that uses a selling broker to execute its 
portfolio securities transactions are likewise clear. We request 
comment on ways to clarify, consolidate, or simplify any part of the 
proposed amendments.
    We do not believe that the use of performance rather than design 
standards is feasible. The proposed amendments would prohibit the use 
of brokerage commissions to finance distribution because the experience 
of our staff, including a recent staff review of brokerage commission 
practices, has led us to believe that the conflicts surrounding this 
practice are unmanageable. The requirement in the proposed amendments 
that funds that rely on selling brokers to execute transactions must 
have in place policies and procedures to prevent the persons making 
brokerage allocation decisions from taking fund sales into account and 
to prohibit directed brokerage agreements is a performance standard, 
because it permits funds or their advisers to implement policies and 
procedures tailored to their organizations.
    We believe that it would be impracticable to exempt small entities 
from the proposed ban. Doing so would deny to small funds and their 
shareholders the protection that we believe they are due. We request 
comment on whether small entities and their shareholders could be 
afforded equal protection other than through a ban on the use of 
brokerage to finance fund sales. We also believe that it would be 
impracticable to exempt small entities that effect fund portfolio 
transactions through a selling broker from the requirement that they 
implement policies and procedures.

H. Solicitation of Comments

    We encourage the submission of comments with respect to any aspect 
of this IRFA. Comment is specifically requested on the number of small 
entities that would be affected by the proposed amendments, and the 
likely impact of the proposals on small entities. Commenters are asked 
to describe the nature of any impact and provide empirical data 
supporting the extent of the impact. These comments will be considered 
in connection with the adoption of the proposed amendments and will be 
reflected in the Final Regulatory Flexibility Analysis.
    Comments should be submitted in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609. Comments also may be submitted 
electronically to the following E-mail address: [email protected]. 
All comment letters should refer to File No. S7-09-04.; this file 
number should be included in the subject line if E-mail is used.\88\
---------------------------------------------------------------------------

    \88\ Comments on the IRFA will be placed in the same public file 
that contains comments on the proposed amendments themselves.
---------------------------------------------------------------------------

IX. Statutory Authority

    The Commission is proposing amendments to rule 12b-1 under the 
Investment Company Act pursuant to the authority set forth in sections 
12(b) [15 U.S.C. 80a-12(b)] and 38(a) [15 U.S.C. 80a-37(a)] of the 
Investment Company Act.

Text of Proposed Rules

    For reasons set forth in the preamble, Title 17, Chapter II of the 
Code of Federal Regulations is proposed to be amended as follows:

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

    1. The authority citation for Part 270 continues to read in part as 
follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.
* * * * *
    2. Section 270.12b-1 is amended by adding new paragraphs (h) and 
(i) to read as follows:


Sec.  270.12b-1  Distribution of shares by registered open-end 
management investment company.

* * * * *
    (h) Notwithstanding any other provision of this section, a company 
may not compensate a broker or dealer for any promotion or sale of 
shares issued by that company by directing to the broker or dealer:
    (1) The company's portfolio securities transactions; or
    (2) Any remuneration, including but not limited to any commission, 
mark-up, mark-down, or other fee (or portion thereof) received or to be 
received from the company's portfolio transactions effected through any 
other broker (including a government securities broker) or dealer 
(including a municipal securities dealer or a government securities 
dealer); and
    (i) Notwithstanding any other provision of this section, a company 
may not direct its portfolio securities transactions to a broker or 
dealer that promotes or sells shares issued by the company, unless the 
company (or its investment adviser) has implemented, and the company's 
board of directors (including a majority of directors who are not 
interested persons of the company) has approved, policies and 
procedures reasonably designed to prevent:
    (1) The persons responsible for selecting brokers and dealers to 
effect the company's portfolio securities transactions, from taking 
into account the brokers' and dealers' promotion or sale of shares 
issued by the company or any other registered investment company; and
    (2) The company, and any investment adviser and principal 
underwriter of the company, from entering into any agreement (whether 
oral or written) or other understanding under which the company 
directs, or is expected to direct, portfolio securities transactions, 
or any remuneration described in paragraph (h)(2) of this section, to a 
broker (including a government securities broker) or dealer (including 
a municipal securities dealer or a government securities dealer) in

[[Page 9737]]

consideration for the promotion or sale of shares issued by the company 
or any other registered investment company.

    By the Commission.

    Dated: February 24, 2004.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-4426 Filed 2-27-04; 8:45 am]
BILLING CODE 8010-01-P