[Federal Register Volume 69, Number 174 (Thursday, September 9, 2004)]
[Rules and Regulations]
[Pages 54728-54734]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-20373]



[[Page 54727]]

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Part II





Securities and Exchange Commission





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17 CFR Part 270



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

  Federal Register / Vol. 69 , No. 174 / Thursday, September 9, 2004 / 
Rules and Regulations  

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release No. IC-26591; File No. S7-09-04]
RIN 3235-AJ07


Prohibition on the Use of Brokerage Commissions To Finance 
Distribution

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission is adopting 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 prohibits funds from 
paying for the distribution of their shares with brokerage commissions. 
The amendments are designed to end a practice that poses significant 
conflicts of interest and may be harmful to funds and fund 
shareholders.

DATES: Effective Date: October 14, 2004.
    Compliance Date: December 13, 2004. Section III of this release 
contains more information on the compliance date.

FOR FURTHER INFORMATION CONTACT: William C. Middlebrooks, Jr., 
Attorney, or Penelope W. Saltzman, Branch Chief, 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 adopting 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'').\1\
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    \1\ Unless otherwise noted, all references to statutory sections 
are to the Investment Company Act of 1940, and all references to 
``rule 12b-1'' or any paragraph of the rule will be to 17 CFR 
270.12b-1, as amended.
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Table of Contents

I. Background
II. Discussion
    A. Ban on Directed Brokerage
    B. Policies and Procedures
    C. Further Amendments to Rule 12b-1
III. Effective and Compliance Dates
IV. Cost-Benefit Analysis
V. Consideration of Promotion of Efficiency, Competition, and 
Capital Formation
VI. Paperwork Reduction Act
VII. Final Regulatory Flexibility Analysis
Statutory Authority
Text of Rule

I. Background

    Funds buy and sell large amounts of securities each year for their 
portfolios.\2\ Fund advisers choose which broker or dealer will effect 
transactions (``executing broker''), and can use commissions to reward 
brokers or dealers for promoting the sale of fund shares (``selling 
brokers''). Brokers are prohibited from conditioning the promotion of 
fund shares on the receipt of brokerage commissions from a fund.\3\ 
Since 1981, however, fund advisers have been permitted to follow a 
disclosed policy ``of considering sales of shares that the fund issues 
as a factor in the selection of broker-dealers to execute portfolio 
transactions, subject to best execution.'' \4\
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    \2\ In 2003 alone, mutual fund securities transactions totaled 
approximately $8.3 trillion. Investment Company Institute, Mutual 
Fund Fact Book 131 (2004) (reporting approximately $4.3 trillion in 
total purchases and approximately $4 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.
    \3\ NASD Conduct Rule 2830(k) (the ``Anti-Reciprocal Rule''). 
See also In the Matter of Morgan Stanley DW Inc., Securities Act 
Release No. 8339 (Nov. 17, 2003) (``Morgan Stanley'') (finding that 
broker-dealer's program for giving marketing preferences to funds in 
exchange for cash and brokerage commissions violated NASD Conduct 
Rule 2830(k)); NASD Charges Morgan Stanley with Giving Preferential 
Treatment to Certain Mutual Funds in Exchange for Brokerage 
Commission Payments, NASD News Release (Nov. 17, 2003) (``NASD News 
Release'') (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).
    \4\ See 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'') (emphasis added). We made this 
statement in our order approving the NASD's amendment to the Anti-
Reciprocal Rule in 1981 to permit NASD members, subject to the 
prohibition, 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.'' See also discussion infra note 10 and accompanying 
text.
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    Last year we conducted a review of current brokerage practices. 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 fund shares.\5\ In some cases transactions are directed 
to selling brokers. In other cases where the selling broker lacks 
capacity to execute fund securities transactions, fund advisers will 
cause the fund to enter into ``step out'' and other types of 
arrangements under which a portion of the commission is directed to the 
selling brokers.\6\ Fund advisers and selling brokers keep track of the 
value of directed brokerage, and if an insufficient amount of brokerage 
is directed to a selling broker, the broker may require compensation 
from the adviser. If the compensation that a selling broker receives 
for distributing shares of a fund (or a fund complex) falls below 
agreed-upon levels, the selling broker may reduce its selling efforts 
for the funds.
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    \5\ See Prohibition on the Use of Brokerage Commissions to 
Finance Distribution, Investment Company Act Release No. 26356 (Feb. 
24, 2004) [69 FR 9726 (Mar. 1, 2004)] (``Proposing Release'').
    \6\ For further description of these practices, see Proposing 
Release, supra note, at nn.12-14 and accompanying text.
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    Pressures to distribute fund shares (or to avoid making payments 
for distribution out of their own assets) have caused advisers to 
direct more fund brokerage (or brokerage dollars) to selling brokers. 
The directed brokerage has been assigned explicit values, recorded, and 
traded as part of increasingly intricate arrangements by which fund 
advisers barter fund brokerage for sales efforts. These arrangements 
are today far from the benign practice that we approved in 1981 when we 
allowed funds to merely consider sales in allocating brokerage.\7\
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    \7\ See supra note 4 and accompanying text.
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    Fund brokerage is an asset of the fund, and its use to pay for 
distribution expenses implicates rule 12b-1, which regulates the use of 
fund assets to pay selling brokers or otherwise finance the sale of 
fund shares.\8\ Rule 12b-1 permits funds to use their assets to pay 
distribution-related costs, subject to certain conditions designed to 
address concerns about the conflicts of interest arising from allowing 
funds to finance distribution.\9\ In 1981, shortly after we

[[Page 54729]]

adopted rule 12b-1 and in light of its adoption, we concluded that ``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.'' \10\
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    \8\ 17 CFR 270.12b-1. Because it is an asset of the fund, fund 
brokerage must be used for the fund's benefit. 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 of 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.'').
    \9\ See Bearing of Distribution Expenses by Mutual Funds, 
Investment Company Act Release No. 11414 (Oct. 28, 1980) [45 FR 
73898 (Nov. 7, 1980)]. In order to rely on rule 12b-1, among other 
requirements, 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. 17 CFR 270.12b-
1(b). We adopted rule 12b-1 pursuant to section 12(b) of the Act, 
which 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. 15 
U.S.C. 80a-12(b). Section 12(b) was intended to protect funds from 
bearing excessive sales and promotion expenses. 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).
    \10\ 1981 Release, supra note 4. (emphasis added). This 
conclusion was stated in our order approving the NASD's amendment to 
its Anti-Reciprocal Rule. See supra notes--and accompanying text.
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    After reviewing the current directed brokerage practices described 
above, in February 2004, we proposed to amend rule 12b-1 to prohibit 
the use of fund brokerage to compensate broker-dealers for selling fund 
shares.\11\ Our proposal was intended to end practices that we 
concluded were inconsistent with the rationale of our 1981 decision and 
involved unmanageable conflicts of interest. The NASD also has proposed 
a corresponding change to its rules.\12\
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    \11\ Proposing Release, supra note 5.
    \12\ Under the proposed rule change, the NASD would eliminate 
the provision of the Anti-Reciprocal Rule that allows NASD members 
to sell shares of funds that follow a disclosed policy of 
considering the sale of fund shares in the selection of executing 
brokers. See 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). The 
proposed amendment currently is under review by the Commission.
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II. Discussion

    We received thirty-three comment letters in response to our 
proposal to ban funds' use of directed brokerage to compensate brokers 
for the sale of fund shares. Twenty-three of these commenters supported 
the proposal, agreeing with our conclusion that the practice of using 
brokerage to reward sales of fund shares involves substantial conflicts 
of interest. Seven commenters opposed the proposed ban.\13\
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    \13\ Some commenters recommended enhanced disclosure of directed 
brokerage practices as an alternative approach. Other commenters 
questioned whether it would be possible to provide effective 
disclosures. After reviewing these comments, we believe that there 
would not be an effective way of providing comprehensive information 
that would allow many fund investors to evaluate a fund adviser's 
use of brokerage and the conflicts involved.
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    We are adopting the amendments to rule 12b-1 substantially as 
proposed. We are taking this action because we have concluded that the 
practice of trading brokerage for sales of fund shares may harm 
investors in mutual funds in at least four ways:
     Adverse Impact on Best Execution of Fund Transactions. The 
decision to use brokerage commissions to pay for distribution poses 
significant conflicts. Fund advisers, whose compensation is based on 
the amount of assets held by the fund, have an incentive to promote the 
sale of fund shares to increase their advisory fees, and to avoid 
having to pay brokers out of their own pockets for selling fund shares 
(``revenue sharing'').\14\ Competition among fund advisers to secure a 
prominent place in selling brokers' distribution networks (``shelf 
space'') has created powerful incentives to direct brokerage based on 
distribution considerations.\15\ This can adversely affect decisions on 
how and where to effect portfolio securities transactions, or how 
frequently to trade portfolio securities.\16\ Because of the practical 
limitations on the ability of fund directors to actively monitor and 
evaluate the motivations behind the selection of brokers to effect 
portfolio securities transactions, we believe that reliance on fund 
directors to police the use of fund brokerage to promote the sale of 
fund shares is not sufficient.\17\
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    \14\ See Proposing Release, supra note 5, at nn. 36-37 and 
accompanying text.
    \15\ See Rich Blake, How High Can Costs Go?, Institutional 
Investor, May 2001, 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.'').
    \16\ See 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#TopOfPage) (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.''). As 
with all other portfolio securities transactions, however, the fund 
adviser has a 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 the Matter of 
Kidder, Peabody & Co., Inc., Investment Advisers Act Release No. 232 
(Oct. 16, 1968). See also Interpretive Release Concerning the Scope 
of Section 28(e) of the Securities Exchange Act of 1934 and Related 
Matters, Securities Exchange Act Release No. 23170 (Apr. 23, 1986) 
[51 FR 16004 (Apr. 30, 1986)]; 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'').
    \17\ For these reasons, the rule provides for a ban, rather than 
the alternative approach, suggested by some commenters, that fund 
boards receive periodic reports about brokerage allocations.
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     Circumvention of Limits on Distribution Expenses. Pursuant 
to section 22(b) of the Investment Company Act,\18\ the NASD prohibits 
its members (i.e., broker-dealers) from selling shares of funds that 
impose excessive sales loads and other distribution costs directly or 
indirectly on shareholders.\19\ By using these directed brokerage 
arrangements, fund advisers and brokers are able to circumvent the NASD 
rules on excessive sales charges, thus undermining the protections 
afforded fund shareholders by those rules and by section 22(b) of the 
Act.
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    \18\ 15 U.S.C. 80a-22(b).
    \19\ NASD Conduct Rule 2830(d). The rule deems a sales charge to 
be excessive if it exceeds the rule's caps. A 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. 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 percent of the offering price. NASD Conduct Rule 
2830(d)(1)(D). The aggregate sales charges of a fund with a rule 
12b-1 fee may not exceed 7.25 percent of the amount invested, 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. NASD Conduct Rule 2830(d)(2)(B), (E)(i). 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. See Order Approving Proposed 
Rule Change Relating to the Limitation of Asset-Based Sales Charges 
as Imposed by Investment Companies, Securities Exchange Act Release 
No. 30897 (July 7, 1992) [57 FR 30985 (July 13, 1992)], at text 
accompanying n.9.
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     Transparency of Distribution Expenses. Under our rules, 
fund investors receive information about fund expenses, including 
distribution expenses, in a fee table contained in every fund 
prospectus, which identifies the amount of sales load, as well as 
``12b-1 fees'' that are deducted from fund assets.\20\ The practice of 
trading brokerage for sales efforts involves costs that are built into 
brokerage commissions, which are treated as capital items rather than 
expenses. Thus, the practice of directing brokerage for distribution of 
fund shares diminishes the transparency of fund distribution costs and 
the ability of an investor or prospective investor to understand the 
amount of those costs.\21\
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    \20\ 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.''
    \21\ In February, we proposed two rules under the Securities 
Exchange Act of 1934 [15 U.S.C. 78a] (``Exchange Act'') that would 
require broker-dealers to provide their customers with specific 
information, at the point of sale and in transaction confirmations, 
regarding the costs and conflicts of interest that arise from the 
distribution of fund shares. See Confirmation Requirements and Point 
of Sale Disclosure Requirements for Transactions in Certain Mutual 
Funds and Other Securities, and Other Confirmation Requirement 
Amendments, and Amendment to the Registration Form for Mutual Funds, 
Securities Exchange Act Release No. 49148 (Jan. 29, 2004) [69 FR 
6438 (Feb. 10, 2004)]. Because we are prohibiting the payment of 
brokerage commissions to finance fund share distribution, funds will 
no longer be able to pay for share distribution with brokerage 
commissions. Thus, we will consider the effect of this prohibition 
when evaluating any further action with regard to disclosures of 
brokerage commissions associated with portfolio securities 
transactions.

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     Consequence of Broker Conflicts. Finally, these practices 
may corrupt the relationship between broker-dealers and their 
customers.\22\ Receipt of brokerage commissions by a broker-dealer for 
selling fund shares creates an incentive for the broker to recommend 
funds that best compensate the broker rather than funds that meet the 
customer's investment needs.\23\ Because of the lack of transparency of 
brokerage commissions and their value to a broker-dealer, customers are 
unlikely to appreciate the extent of this conflict.
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    \22\ See, e.g., Morgan Stanley, supra note 3 (finding broker-
dealer had willfully violated section 17(a)(2) of the Securities Act 
of 1933 [15 U.S.C. 77q(a)(2)] and rule 10b-10 [17 CFR 240.10b-10] 
under the Exchange Act by failing to disclose to its customers 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; also finding broker-
dealer had violated NASD Rule 2830(k), which essentially prohibits 
NASD members from favoring the sale of mutual fund shares based on 
the receipt of brokerage commissions); NASD News Release, supra note 
3. 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.
    \23\ See Ruth Simon, Why Good Brokers Sell Bad Funds, Money, 
July 1991, at 94.
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A. Ban on Directed Brokerage

    Rule 12b-1(h)(1) prohibits funds from compensating a broker-dealer 
for promoting or selling fund shares by directing brokerage 
transactions to that broker.\24\ The prohibition applies both to 
directing transactions to selling brokers, and to indirectly 
compensating selling brokers by participation in step-out and similar 
arrangements in which the selling broker receives a portion of the 
commission.\25\ The ban extends to any payment, including any 
commission, mark-up, mark-down, or other fee (or portion of another 
fee) received or to be received from the fund's portfolio transactions 
effected through any broker or dealer.\26\
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    \24\ Rule 12b-1(h)(1). The rule prohibits 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 processing a brokerage transaction. The prohibition reaches 
transactions executed by government securities dealers and municipal 
securities dealers.
    \25\ Rule 12b-1(h)(1)(ii). The prohibition also extends to 
circumstances in which two funds cooperate to direct brokerage 
commissions to the selling broker of the other fund. See section 48 
under the Act [15 U.S.C. 80a-47(a)] (making it unlawful for a person 
to do indirectly what the person could not do directly).
    \26\ Rule 12b-1(h)(1)(ii).
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B. Policies and Procedures

    The amendments we are adopting today recognize that many funds are 
likely to find that, for some portfolio transactions, the broker-dealer 
who can provide best execution also distributes the fund's shares. The 
prohibition we adopt today is not intended to compromise best 
execution. Nevertheless, the fact that a selling broker provides best 
execution would not cure a violation of the prohibition on funds or 
their advisers directly or indirectly compensating the broker for 
promoting fund shares with payments from portfolio transactions. Rule 
12b-1(h)(2) permits a fund to use its selling broker to execute 
transactions in portfolio securities \27\ only if the fund or its 
adviser has implemented policies and procedures designed to ensure that 
its selection of selling brokers for portfolio securities transactions 
is not influenced by considerations about the sale of fund shares.\28\ 
These procedures must be approved by the fund's board of directors, 
including a majority of the independent directors, and must be 
reasonably designed to prevent: (i) The persons responsible for 
selecting broker-dealers to effect transactions in fund portfolio 
securities transactions (e.g., trading desk personnel) from taking into 
account, in making those decisions, broker-dealers' promotional or 
sales efforts,\29\ and (ii) the fund, its adviser and principal 
underwriter from entering into any agreement or other understanding 
under which the fund directs brokerage transactions or revenue 
generated by those transactions to a broker-dealer to pay for 
distribution of the fund shares.\30\ These procedures must be designed 
to prevent funds from entering into informal arrangements to direct 
portfolio securities transactions to a particular broker.\31\
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    \27\ Some commenters expressed concern that the rule would 
inhibit funds from using selling brokers to execute fund brokerage 
transactions, and requested that the Commission clarify that the 
rule does not prohibit a fund from using a selling broker to execute 
brokerage transactions.
    \28\ Rule 12b-1(h)(2). See supra note 16.
    \29\ Rule 12b-1(h)(2)(ii)(A).
    \30\ Rule 12b-1(h)(2)(ii)(B). This provision should be 
interpreted broadly 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 dealer or a municipal securities dealer, or an 
understanding in which each of two funds directs brokerage to the 
other fund's selling broker.
    \31\ Under our compliance rule, a fund's compliance officer is 
required to report annually to the board regarding the operation of 
the fund's policies and procedures, including policies and 
procedures to ensure that brokerage allocation is not influenced by 
considerations of fund distribution. 17 CFR 270.38a-1(a)(4)(iii)(A). 
Therefore, we did not include a provision in the rule, as suggested 
by some commenters, that would require periodic reporting of 
brokerage allocation to the board.
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    The procedures should be incorporated into each fund's compliance 
policies and procedures, which each fund is required to adopt by our 
rule 38a-1.\32\ Fund chief compliance officers should assure themselves 
that the required procedures are in place as well as any others that 
they believe are reasonably necessary to prevent violation of the 
prohibition against directing brokerage for sales of fund shares. 
Compliance officers of broker-distributed funds should monitor the 
operation of the policies and procedures, and should consider periodic 
testing of brokerage allocations to determine whether there is a 
significant correlation between sales and the direction of brokerage 
that may suggest the existence of informal arrangements in violation of 
the rule.
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    \32\ 17 CFR 270.38a-1.
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    Several commenters urged that we modify the rule to incorporate a 
safe harbor for funds that use selling brokers to execute portfolio 
securities transactions. Many of these commenters asserted that without 
a safe harbor included in the amended rule, funds would be discouraged 
from selecting selling brokers to execute portfolio transactions. We 
believe that a safe harbor is unnecessary. As described above, we are 
requiring instead that funds that select their selling brokers to 
execute trades implement policies and procedures designed to ensure 
that those selections are based on the quality of the execution rather 
than the promotion of fund shares.\33\ The inclusion of this 
requirement acknowledges that, consistent with the ban we are adopting 
today, there will be some instances, in which funds will execute 
portfolio securities transactions through their selling brokers.
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    \33\ Rule 12b-1(h)(2).
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C. Further Amendments to Rule 12b-1

    We also requested comment on the need for further amendments to 
rule 12b-1, including the rescission of the rule. We received 
approximately 1,650 comments in response to this request for comment. 
Comment letters provided a number of alternatives and suggestions that 
we have asked the staff to explore.

[[Page 54731]]

These included an approach set forth in the Proposing Release that 
would refashion rule 12b-1 to provide that funds deduct distribution-
related costs directly from shareholder accounts rather than from fund 
assets.\34\ Commenters also addressed concerns regarding revenue 
sharing. We will take these and other comments we received into 
consideration as we evaluate whether and how to amend the rule further. 
We are not adopting any further changes to rule 12b-1 today.
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    \34\ See Proposing Release, supra note 5, at nn. 63-67 and 
accompanying text.
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III. Effective and Compliance Dates

    The amendments to rule 12b-1 will be effective on October 14, 2004. 
The compliance date of these rule amendments is December 13, 2004. No 
later than the compliance date, funds must be in compliance with the 
ban in paragraph (h)(1) of the rule and funds that use their selling 
brokers to execute portfolio securities transactions must have in place 
the policies and procedures prescribed by paragraph (h)(2)(ii) of rule 
12b-1. Funds may make corresponding changes to their registration 
statements at the time of the next regularly scheduled amendment.

IV. Cost-Benefit Analysis

    We are sensitive to the costs and benefits that result from our 
rules. The amendments prohibit the use of brokerage commissions to 
compensate broker-dealers for the distribution of fund shares. In the 
Proposing Release, we requested comment and specific data regarding the 
costs and benefits of the proposed amendments.\35\ We received no 
comments on the costs and benefits of the proposed amendments.
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    \35\ See Proposing Release, supra note 5, at section V.C.
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A. Benefits

    The amendments will benefit funds and their shareholders. The 
practice of directing brokerage for sales involves substantial 
conflicts of interest that can harm shareholders. Fund advisers control 
fund brokerage and, as a result of their compensation structures, have 
incentives to maximize the size of funds they advise, while fund 
shareholders are interested in maximizing their fund returns by 
minimizing overall costs, including transaction costs. Fund advisers 
that overtrade fund portfolio securities in order to generate 
additional sales of fund shares, or that fail to optimize transactions 
costs, impose real costs on fund investors, which these rule amendments 
seek to eliminate. The opaqueness of fund transaction costs makes it 
impossible for investors to control the conflict or to understand the 
amount of actual costs incurred for distribution of fund shares.
    The elimination of the practice of directing fund brokerage for 
distribution also may yield secondary benefits to funds if it leads to 
lower institutional brokerage rates, lower portfolio turnover rates, 
and better transparency of distribution costs. The Commission has no 
way of quantifying these benefits.

B. Costs

    The amendments may decrease the commissions received by broker-
dealers who may seek to make up for any shortfall from other sources. 
In response, fund advisers may seek to increase sales loads paid by 
investors, or to increase the amount of payments to broker-dealers 
deducted from fund assets under a rule 12b-1 plan. The ability of 
advisers to obtain these funds is, however, subject to NASD limits, and 
by the requirement that fund shareholders approve increases to fees 
deducted pursuant to a rule 12b-1 plan. Alternatively, advisers may be 
required to increase the payments that they make to broker-dealers out 
of their own assets, which are likely to cause advisers' costs to 
rise.\36\ Advisers may resist making these payments because of 
uncertainty that they may be recouped.
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    \36\ Advisers may seek to increase their management fees to 
offset increased payments to broker-dealers. Any increase in 
management fees would have to be approved by the fund's 
shareholders. See 15 U.S.C. 80a-15(a).
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    We assume that a great many, 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. These funds 
will incur costs in order to comply with the requirement for policies 
and procedures contained in the amendments.\37\ Specifically, these 
funds 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 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.
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    \37\ 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.
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    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.\38\
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    \38\ Historically, however, fund shareholders have not always 
enjoyed lower expenses as a result of increased assets (the absence 
of lower expenses can result from a number of causes, including that 
advisers are failing to pass on scale economies to shareholders or 
that advisers are not themselves earning scale economies).
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V. 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.\39\
---------------------------------------------------------------------------

    \39\ 15 U.S.C. 80a-2(c).
---------------------------------------------------------------------------

    As discussed above, the amendments 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 will 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.
    We do not anticipate that these amendments will harm competition; 
they are, in fact, intended to enhance competition. All funds are 
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.

[[Page 54732]]

    Although we do not anticipate that these amendments will adversely 
impact competition, we do not know whether these amendments will affect 
all funds in the same manner. Certain types of portfolio managers, for 
instance, might rely more heavily on directed brokerage to ensure 
adequate shelf space for the funds they advise than other advisers, 
which could result in an increase in some funds' costs. The ban on 
directed brokerage to pay for distribution also could lead to an 
increase in costs for some funds if the amendments compel the fund to 
modify the way it distributes its shares. This potential differential 
impact on funds could affect competition.
    The amendments 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 will not be 
unnecessarily limited in their choice of executing brokers, and the 
amendments will not have adverse effects on competition in the 
provision of brokerage services. We do not anticipate that the 
amendments will affect capital formation.

VI. Paperwork Reduction Act

    As explained in the Proposing Release, the amendments contain a 
``collection of information'' requirement within the meaning of the 
Paperwork Reduction Act of 1995 (``PRA'').\40\ We published notice 
soliciting comments on the collection of information requirements in 
the Proposing Release and submitted these requirements 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 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 
OMB control number for rule 12b-1 is 3235-0212.
---------------------------------------------------------------------------

    \40\ 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.
    As discussed above, today we are adopting amendments to rule 12b-1 
substantially as proposed. To eliminate a practice that poses 
significant conflicts of interest and may be harmful to funds and fund 
shareholders, we are amending rule 12b-1 to prohibit funds from paying 
for the distribution of their shares with brokerage commissions. Funds 
that use their selling brokers to execute securities transactions will 
be required to implement, and their boards of directors (including a 
majority of independent directors) to approve, policies and procedures. 
The policies and procedures must 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 are mandatory. 
Responses provided to the Commission in the context of its examination 
and oversight program are generally kept confidential.\41\ None of the 
commenters addressed the PRA burden associated with these amendments. 
OMB approved the information collection requirements.\42\
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    \41\ See section 31(c) of the Investment Company Act [15 U.S.C. 
80a-30(c)].
    \42\ In the Proposing Release, we estimated that the aggregate 
burden for all funds in the first year after adoption would be 
649,500 hours. We further estimated that the average weighted annual 
burden for all funds over the three-year period for which we 
requested approval of the information collection burden would be 
approximately 628,833 hours. See Proposing Release, supra note 5, at 
section VII.
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VII. Final Regulatory Flexibility Analysis

    This Final Regulatory Flexibility Analysis has been prepared in 
accordance with 5 U.S.C. 604. It relates to the amendments to rule 12b-
1, which governs the use of fund assets to finance the distribution of 
fund shares. The Initial Regulatory Flexibility Analysis (``IRFA''), 
which was prepared in accordance with 5 U.S.C. 603, was published in 
the Proposing Release.\43\
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    \43\ See Proposing Release, supra note 5, at section VIII.
---------------------------------------------------------------------------

A. Reasons for the Proposed Action

    As described more fully in Section I of this Release, the 
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 poses significant 
conflicts of interests and may be harmful to funds and fund 
shareholders.

B. Significant Issues Raised by Public Comment

    When the Commission proposed the rule amendments that it is now 
adopting, it requested comment with respect to the proposal and the 
accompanying IRFA. We received no comments on the IRFA. Twenty-three 
commenters supported the Commission's proposal to ban the use of 
directed brokerage to finance distribution. Commenters noted that the 
practice gives rise to conflicts of interest, causes shareholders to be 
treated inequitably, may lead to portfolio churning in order to 
generate brokerage commissions, facilitates circumvention of the NASD's 
limits on sales charges, may result in inappropriate recommendations by 
brokers to their customers, and increases execution costs for funds.
    Seven commenters opposed the ban on the use of brokerage 
commissions to pay for distribution. They argued that the proposed ban 
is unnecessary to protect investors and would inhibit the ability of 
funds to obtain best execution, increase commission rates by 
concentrating the brokerage business among fewer brokers, and eliminate 
a method of compensating broker-dealers for processing fund 
transactions and maintaining customer accounts. Opposing commenters 
offered the following alternatives to the proposed ban: (i) Enhanced 
disclosure of directed brokerage arrangements; (ii) Commission guidance 
about improper

[[Page 54733]]

arrangements; (iii) requiring funds to adopt policies and procedures 
governing brokerage allocation practices; (iv) as with other fund 
assets, prohibiting the use of brokerage commissions for distribution 
unless they are used in accordance with a rule 12b-1 plan; and (v) 
enhanced review and enforcement efforts with respect to existing 
restrictions on the use of directed brokerage.

C. Small Entities Subject to the Rule

    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.\44\ Of approximately 5,124 registered 
investment companies, approximately 204 are small entities.\45\ As 
discussed above, the amendments prohibit all funds, regardless of size, 
from using portfolio brokerage commissions to finance distribution. All 
funds that use selling brokers to execute portfolio transactions must 
implement policies and procedures. While we have no reason to expect 
that small entities will be disproportionately affected by the 
amendments, it is possible that a larger portion of smaller funds 
secure shelf space through the use of directed brokerage than is the 
case with larger funds. If true, smaller funds could incur some 
unanticipated costs as they adapt to these amendments.
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    \44\ 17 CFR 270.0-10.
    \45\ 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.
---------------------------------------------------------------------------

D. Reporting, Recordkeeping, and Other Compliance Requirements

    The amendments do not include any new reporting or recordkeeping 
requirements. The amendments 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, are 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 must approve 
these policies and procedures.

E. Commission Action To Minimize Effect on Small Entities

    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.
    We do not believe that clarification, consolidation, or 
simplification of the compliance requirements is feasible. The 
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 do not believe that the use of performance rather than design 
standards is feasible. The amendments 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 largely unmanageable. The requirement 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 ban. Doing so would deny to small funds and their shareholders 
the protection that we believe they are due. 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.

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.

List of Subjects in 17 CFR Part 270

    Investment companies, Securities.

Text of Rule

0
For reasons set forth in the preamble, Title 17, Chapter II of the Code 
of Federal Regulations is amended to read as follows:

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

0
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.
* * * * *

0
2. Section 270.12b-1 is amended by:
0
a. Removing the periods at the end of paragraphs (a)(1) and (a)(2) and 
adding semi-colons in their places;
0
b. Removing the word ``and'' at the end of paragraphs (b)(2) and 
(b)(3)(iii);
0
c. Removing the comma at the end of the introductory text of paragraph 
(b)(3)(iv) and adding a colon in its place;
0
d. Removing the word ``and'' at the end of paragraph (b)(3)(iv)(B);
0
e. Adding the word ``and'' at the end of paragraph (b)(4);
0
f. Removing the word ``and'' at the end of paragraph (e);
0
g. Removing the period at the end of paragraph (f) and adding a semi-
colon in its place;
0
h. Removing the period at the end of paragraph (g) and adding ``; and'' 
in its place; and
0
i. Adding paragraph (h).
    The addition reads as follows.

[[Page 54734]]

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:
    (1) Compensate a broker or dealer for any promotion or sale of 
shares issued by that company by directing to the broker or dealer:
    (i) The company's portfolio securities transactions; or
    (ii) 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
    (2) 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):
    (i) Is in compliance with the provisions of paragraph (h)(1) of 
this section with respect to that broker or dealer; and
    (ii) 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:
    (A) 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
    (B) 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)(1)(ii) of this section, 
to a broker (including a government securities broker) or dealer 
(including a municipal securities dealer or a government securities 
dealer) in consideration for the promotion or sale of shares issued by 
the company or any other registered investment company.

    By the Commission.

    Dated: September 2, 2004.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-20373 Filed 9-8-04; 8:45 am]
BILLING CODE 8010-01-P