Investment Company Act of 1940 - Rule 12b-1 and Section 18(f), 22(d) and 48(a)
E*TRADE Securities, LLC
November 30, 2005
By letter dated November 28, 2005, you request that we clarify certain statements we made in Edward Mahaffy (pub. avail. March 17, 2003) (the "Mahaffy Letter") concerning the proposal of a registered representative of a broker-dealer to rebate to its customers a portion of the Rule 12b-1 fees that it received from open-end investment companies ("funds").
E*TRADE Securities LLC ("E*TRADE") and E*TRADE Clearing LLC ("E*TRADE Clearing") are registered broker-dealers.1 You state that E*TRADE has entered into agreements with numerous funds and their affiliated persons pursuant to which E*TRADE is paid 12b-1 fees authorized pursuant to the funds' 12b-1 plans for providing services that are primarily intended to result in the sale of the funds' shares. You further state that certain funds also pay fees to E*TRADE for providing administrative services; those fees may or may not be paid pursuant to 12b-1 plans.
You state that E*TRADE currently offers rebates with respect to more than 5,000 funds under its rebate program (the "Program"), and you state that E*TRADE developed the Program to: (1) attract new customers to E*TRADE; (2) attract additional fund assets from its existing customers who have accounts elsewhere; and (3) provide a "persistency bonus" for customers who maintain active accounts at E*TRADE.2 As described in greater detail in your letter, E*TRADE pays rebates on a semi-annual basis to each customer ("Eligible Customer") who: (1) had an active E*TRADE brokerage account or individual retirement account with E*TRADE (either, an "E*TRADE Account") at the end of the relevant period; and (2) held shares of funds included by E*TRADE in the Program in his or her E*TRADE Account at any time during that period. E*TRADE includes in the Program all funds available through its mutual fund supermarket and from which E*TRADE receives 12b-1 fees and/or administrative fees ("Program Funds") except any funds that are affiliated persons of E*TRADE.3
You state that E*TRADE pays a rebate to each Eligible Customer based upon the aggregate amount of 12b-1 fees and/or administrative fees that E*TRADE receives as a result of Program Fund shares held by an Eligible Customer in his or her Eligible Customer Account during the relevant semi-annual period. You further state that E*TRADE will pay the rebate regardless of whether the Eligible Customer purchased Program Fund shares through his or her E*TRADE Account or transferred such shares to the E*TRADE Account from an account with another broker-dealer. You also state that E*TRADE pays the rebates out of its general assets, but that the amount is computed based on 12b-1 fees and administrative fees attributable to the Eligible Customer's E*TRADE Account for ease of calculation and clarity to the customer. In some cases, you note that a rebate paid to a particular Eligible Customer may exceed the 12b-1 fees and administrative fees received by E*TRADE and attributable to that customer's E*TRADE Account during the relevant period.
You state that E*TRADE developed and operates the Program in its sole discretion, completely independently of any funds or fund affiliate, and that E*TRADE is not and will not be affiliated with a Program Fund or with any affiliate of such a fund. You also state that E*TRADE is not seeking and will not seek any approval from a fund or any of the fund's affiliates before rebating any fees to Eligible Customers. You further state that the Program is not and will not be the subject of any agreement or arrangement, written or otherwise, between E*TRADE and a Program Fund or any affiliate of such a fund. E*TRADE, however, may notify a fund, as well as its sponsor, investment adviser and principal underwriter, that the fund will be included in the Program. Upon inquiry, E*TRADE also will provide information to a fund and its principal underwriter about the extent to which E*TRADE rebates to its customers 12b-1 fees paid to it by the fund.
You state that some funds affirmatively have requested that they not be included in the Program. These funds, you assert, have interpreted our statements in the Mahaffy Letter as suggesting that if a broker-dealer rebated 12b-1 fees to its customers, a fund's board of directors ("board") could never determine, as required by Rule 12b-1(e), that there is a reasonable likelihood that the 12b-1 plan would benefit the fund and its shareholders.4 You note that the practical effect of this position would be that broker-dealers could not offer customers rebate programs similar to the Program, and you question whether this was our intent. As explained below, it was not. We merely pointed out that the willingness to rebate a portion of 12b-1 fees to brokerage customers raised questions for consideration by the board in its review and approval of a fund's 12b-1 plan.5
Section 12(b) of the Investment Company Act generally makes it unlawful for any 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 the Commission may prescribe.6 Rule 12b-1 prohibits a fund from using its assets to pay for distribution unless certain requirements are satisfied.7 Among other things, any distribution payments by a fund must be made pursuant to a written plan (i.e., a 12b-1 plan) that has been approved by the fund's shareholders and by the fund's board.8 Rule 12b-1 also requires a fund's board to approve the continuation of the 12b-1 plan annually.9 In deciding whether to approve a 12b-1 plan, a fund's board must request and evaluate, and any person who is a party to any agreement with the fund relating to the fund's 12b-1 plan must furnish to the board, "such information as may reasonably be necessary to an informed determination of whether such plan should be implemented or continued . . . ."10 In addition, before a fund's board approves the implementation or continuation of a fund's 12b-1 plan, the board must "consider and give appropriate weight to all pertinent factors . . . ,"11 and conclude, in the exercise of reasonable business judgment and in light of its fiduciary duties under state law and under Sections 36(a) and (b) of the Investment Company Act, that there is a reasonable likelihood that the plan will benefit the fund and its shareholders.12
Our statements in the Mahaffy Letter reflect our general concern that a fund's board should be attentive to how the fund's shares are distributed and how the fund's assets are used for distribution.13 We stated that, pursuant to Rule 12b-1(d), a fund's board should consider broker-dealer rebates of the fund's 12b-1 fees as a pertinent factor in reaching the board's conclusion with respect to the fund's 12b-1 plan.14 We did not, however, intend our statements in the Mahaffy Letter to mean that a fund's board could never approve the fund's 12b-1 plan if a broker-dealer was rebating 12b-1 fees to its customers. Rather, the appropriateness of a board's determination would depend upon all of the relevant facts and circumstances. For example, if all or almost all of the 12b-1 fees that a fund paid to broker-dealers under its 12b-1 plan were being rebated, the fund's board might reasonably conclude, in the exercise of its business judgment, that the continuation of the plan at the current level was no longer reasonably likely to benefit the fund and its shareholders. In that event, the board might reasonably determine to discontinue the plan or to amend the plan by reducing the amount of the 12b-1 fees paid by the fund.
In addition, we note that rebate programs other than described in your letter and above may raise further issues. For example, some funds might seek to implement rebate programs in coordination or in concert with one or more broker-dealers. We believe that if a fund entered into any agreement or arrangement, written or oral, with one or more broker-dealers pursuant to which the broker-dealers rebated 12b-1 fees to select shareholders of a class of the fund's securities, the fund would be indirectly treating some shareholders differently.15 Such conduct would raise serious concerns under the Investment Company Act and general fiduciary principles.16 A fund that selectively rebates 12b-1 fees and/or administrative fees to shareholders indirectly through broker-dealers also may violate Sections 18(f),17 22(d)18 and 48(a)19 of the Investment Company Act. To the extent that a broker-dealer entered into such an agreement or arrangement with the fund, the broker-dealer could be liable for aiding and abetting and/or causing the fund's misconduct.
If you have questions about this letter, you may telephone Martin Kimel, Senior Counsel, or me at (202) 551-6825.
Elizabeth G. Osterman
Assistant Chief Counsel