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News December 19, 2005 Issue

Funds Needn’t Shy Away From 12b-1 Rebating Programs, Says IM Staff

Just because some brokers might choose to attract retail customers by offering to rebate a portion of a fundís 12b-1 fees, doesnít mean that the 12b-1 plan isnít a good idea for the fund.

That was the thrust of a no-action letter recently issued to E*TRADE Securities. The web-based broker-dealer launched a 12b-1 rebating program back in 2003, a few months after the SECís Division of Market Regulation issued a no-action letter on the topic to Edward Mahaffy, a Raymond James registered rep. Apparently, some statements made by the Division of Investment Management staff in the Mahaffy letter made funds a bit nervous about participating in E*TRADEís rebating program.

So E*TRADE wrote in to clear up the air.

The issue in the Mahaffy letter was whether the rep could rebate a portion of his 12b-1 fees to customers, even though his customers were not broker-dealers and therefore technically could not receive commissions. Mahaffy sought confirmation that he could rebate the fees without violating the Exchange Act

The staff of Market Reg granted the relief. However, the Division of Investment Management chimed in on the response, questioning whether "direct or indirect rebates of 12b-1 fees by a fund are consistent with the policies and provisions of the 1940 Act." The IM staff cautioned Mahaffy that a brokerís practice of rebating to its customers all or a portion of 12b-1 fees paid by the fund to the broker "would be a pertinent factor requiring a board of directorsí full consideration in reaching its conclusion with respect to a fundís 12b-1 plan." The staff additionally questioned whether a 12b-1 plan under which brokers rebate 12b-1 fees to their customers "would benefit the fund and its shareholders."

In its request, E*TRADE noted that since it launched its rebate program, some funds groups have asked that their fund not be included. E*TRADE suspected that these funds interpreted the IM staffís statements in the Mahaffy letter as suggesting that if a broker rebated 12b-1 fees to its customers, a fundís board could never make the determination required by Rule 12b-1 that there is a reasonable likelihood that the 12b-1 plan would benefit the fund and its shareholders. E*TRADE politely asked the IM staff if this is what they had intended.

Noting that the staff really hadnít had an opportunity to consider specific facts or legal analysis on this point in the Mahaffy letter, the firm described its rebate program in detail: The program provides E*TRADE brokerage customers with a rebate equivalent to 50 percent of the value of 12b-1 fees and other service fees paid on their fund shares (E*TRADE noted that the rebate could be funded out of 12b-1 fees or service fees, or out of the firmís own profits). E*TRADE also emphasized that the program would be run free of influence by any fund. The reason it is able to offer the rebate, it explained, is because of E*TRADEís business model, which emphasizes technology, and low operating expenses ("the company does not have an extensive, high cost network of brokers," said the firm).

The staff confirmed E*TRADEís hunch that funds might have been overly concerned about the statements in the Mahaffy letter. The staff explained that the Mahaffy letter was not intended to suggest that if a broker rebated 12b-1 fees to its customers, a fundís board of directors could never determine, as required by Rule 12b-1, that there is a reasonable likelihood that the 12b-1 plan would benefit the fund and its shareholders.

The Mahaffy letter, said the staff, merely pointed out that a brokerís willingness to rebate a portion of 12b-1 fees to its customers should raise questions to be considered by the board when reviewing and approving a fundís 12b-1 plan. "Our statements in the Mahaffy Letter reflect our general concern that a fundís board should be attentive to how the fundís shares are distributed and how the fundís assets are used for distribution," explained the staff. It noted that "the appropriateness of a boardís determination" would depend upon 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," said the staff, a fund 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 such a circumstance, the board might reasonably decide to discontinue the plan or to reduce the amount of the 12b-1 fees paid by the fund.

In addition, the staff cautioned against specific funds attempting to enter into agreements about rebate programs with 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 fundís securities, the fund would be indirectly treating some shareholders differently," warned the staff. Such arrangements would raise "serious concerns" under the 1940 Act and general fiduciary principles, it said. The staff also cautioned that a broker-dealer that entered into a rebate arrangement in coordination with a fund could be liable for aiding and abetting or causing the fundís misconduct.