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Investment Company Act of 1940 - Rule 12b-1 and Section 18(f), 22(d) and 48(a)

E*TRADE Securities, LLC

November 30, 2005

RESPONSE OF THE OFFICE OF CHIEF COUNSEL
DIVISION OF INVESTMENT MANAGEMENT Our Ref. No. 2005511
E*TRADE Securities, LLC

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").

BACKGROUND

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.

DISCUSSION

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.

Sincerely,

Elizabeth G. Osterman

Assistant Chief Counsel

Endnotes

¹	ETRADE Clearing and ETRADE are affiliated persons within the definition of Section 2(a)(3) of the Investment Company Act. ETRADE and ETRADE Clearing are collectively referred to as "E*TRADE" solely for purposes of this response.
²	You state that an "active account" is one that is open at the end of a semi-annual period with a minimum balance of $25.
³	In addition, ETRADE, in its sole discretion, may not include in the Program a fund that has asked ETRADE not to be included.
⁴	We expressed our view in the Mahaffy Letter that a broker-dealer's proposed practice of rebating to its customers all or a portion of the 12b-1 fees paid by the fund to the broker-dealer would be "a pertinent factor requiring a board of director's full consideration" in deciding whether the fund's 12b-1 plan was reasonably likely to benefit the fund and its shareholders. We also generally questioned "whether a 12b-1 plan under which broker-dealers rebate 12b-1 fees to their customers would benefit the fund and its shareholders."
⁵	See discussion below.
⁶	Rule 12b-1(a)(2) provides that a fund is acting as a distributor of securities of which it is the issuer, other than through an underwriter, if it engages directly or indirectly in financing any activity that is primarily intended to result in the sale of fund shares.
⁷	Rule 12b-1 is intended to protect funds from conflicts that may exist when fund assets are used in a way that benefits the fund's investment adviser. See Bearing of Distribution Expenses by Mutual Funds, Investment Company Release No. 11414 (Oct. 28, 1980) (adopting Rule 12b-1) ("Rule 12b-1 Adopting Release"). See also Bearing of Distribution Expenses by Mutual Funds, Investment Company Release No. 10862 (Sept. 7, 1979) (proposing Rule 12b-1); Investment Company Institute (pub. avail. Oct. 30, 1998).
⁸	Rule 12b-1(b)(1) and (2).
⁹	Rule 12b-1(b)(3).
¹⁰	Rule 12b-1(d). See, e.g., In the Matter of PA Fund Management LLC, Investment Company Act Release No. 26598 (Sept. 15, 2004) (funds' distributor violated Rule 12b-1(d) by failing to disclose to the funds' board directed brokerage arrangements designed to promote the sale of the funds' shares).
¹¹	Rule 12b-1(d). Rule 12b-1(d) also provides that "minutes describing the factors considered and the basis for the board's decision to use [fund] assets for distribution must be made and preserved in accordance with [Rule 12b-1(f)]."
¹²	Rule 12b-1(e).
¹³	See Rule 12b-1 Adopting Release, supra note 7 (the Commission suggested specific factors that it believed would normally be relevant to a fund board's determination of whether to use fund assets for distribution, including the nature and approximate amount of the expenditures under the plan and, in deciding whether to continue a plan, whether it has produced its anticipated benefits).
¹⁴	A board would have to consider the extent to which 12b-1 fees paid by the fund to broker-dealers are rebated by the broker-dealers to reach an informed determination of whether to continue the fund's 12b-1 plan. Under Rule 12b-1(d), the fund's principal underwriter would be required to provide such information to the board. See supra text accompanying note 10. Rule 12b-1(b) requires that "all agreements with any person relating to implementation" of a fund's 12b-1 plan must be approved by the fund's board. You state your view that an inquiry by a fund or its principal underwriter about the extent to which a broker-dealer rebated 12b-1 fees paid to it by the fund would not, by itself, constitute an agreement or arrangement between the broker-dealer and the fund that requires consideration by the board under Rule 12b-1(b). We agree.
¹⁵	We note that the inquiry described in note 14, supra, would not, without more, constitute such an agreement or arrangement.
¹⁶	See Southeastern Growth Fund (pub. avail. May 22, 1986) (proposed waiver or rebate of 12b-1 fees by fund for one fund shareholder raised significant issues under Rule 12b-1, Section 36 of the Investment Company Act and general fiduciary principles). Accord Chairman John D. Dingell (pub. avail. Oct. 14, 1986).
¹⁷	Section 18(f) generally prohibits a fund from selling any class of senior securities. Funds seeking to offer investors a choice of methods for paying for the costs of selling fund shares, however, may issue multiple classes of voting securities subject to different fees and expenses, including different 12b-1 fees, in accordance with Rule 18f-3.
¹⁸	Section 22(d) prohibits a fund, its principal underwriter and dealers from selling fund shares at a price other than the current offering price set forth in the fund's prospectus. Broker-dealers may violate Section 22(d) of the Investment Company Act by providing benefits to investors in connection with their purchase of fund shares. See, e.g., Murphy Favre (pub. avail. May 22, 1987) (stating that a broker-dealer's proposal to provide discount travel coupons to investors in connection with their purchase of fund shares generally would violate Section 22(d)). To the extent that rebates of 12b-1 fees and administrative fees under a rebate program do not offset the current offering price set forth in a fund's prospectus, however, we believe that they would not violate Section 22(d). See Portico Funds (pub. avail. Apr. 11, 1996). In this regard, we particularly note your representation that ETRADE will pay the rebates to Eligible Customers regardless of whether they purchase Program Fund shares through ETRADE or whether they transfer Program Fund shares to their E*TRADE Accounts after purchasing them elsewhere.
¹⁹	Section 48(a) of the Investment Company Act, in part, makes it unlawful for any person to do any act or thing indirectly "through or by means of any other person" which it would be unlawful for such person to do directly under the Act or rules thereunder.

Incoming Letter

The Incoming Letter is in Acrobat format.

http://www.sec.gov/divisions/investment/noaction/etrade113005.htm