1 In its 1992 report on investment company regulation, the
staff of the Division of Investment Management recommended that
the Commission adopt proposed Rule 6c-10, "with certain
modifications" relating to the mechanics of the rule.
April 4, 1994
TO: SEC RULES COMMITTEE NO. 44-94
RE: ISSUES RELATING TO PROPOSED RULE 6c-10
__________________________________________________________
Introduction
In 1988, the Securities and Exchange Commission proposed Rule
6c-10 under the Investment Company Act of 1940, to permit mutual
funds to impose contingent and non-contingent deferred sales loads
without first obtaining exemptive relief from the Commission. In
response to this proposal, the Institute filed a comment letter
generally supporting the provisions relating to contingent deferred
sales loads but opposing the non-contingent deferred load portion
of the proposal. To this date, there has been no further
Commission action on the proposed rule. 1
Currently, however, the Commission is considering another
rule proposal (Rule 18f-3) that would permit mutual funds to issue
multiple classes of shares without having to seek an exemptive
order. Insofar as most funds with multiple classes impose a
contingent deferred sales load on at least one class of shares, and
at present must obtain exemptive relief to do so, we understand
that it is likely that the Commission will adopt proposed Rule 6c-
10 in some form at the time it adopts the multiple class proposal.
Therefore, at the April 12th meeting of the SEC Rules
Committee, we will ask the Committee to discuss whether any
significant concerns remain in connection with the possible
adoption of Rule 6c-10. As background for the discussion, this
memorandum summarizes the issues the Institute identified in its
1989 comment letter on proposed Rule 6c-10, recent comment letters
filed in support of the rule proposal, and certain developments in
the area of mutual fund distribution since Rule 6c-10 originally
was proposed. Copies of the Institute's comment letter and the
recent comment letters are attached.
Institute Comment Letter
As noted above, the Institute's comment letter on proposed
Rule 6c-10 generally supported the codification of exemptive relief
for the imposition of contingent deferred sales loads. We
suggested, however, that the NASD regulate these charges; that fund
complexes be permitted to continue to rely on previously issued
exemptive orders as to existing funds as well as funds created in
the future; and that the proposed definition of contingent deferred
sales load be modified slightly.
With respect to non-contingent deferred loads (in particular,
installment loads), the Institute's letter characterized the
Commission's proposal as "uneconomic and unworkable." The letter
criticized the proposal on the basis that it dealt with an area in
which the staff had no experience and the industry had no interest.
The Institute also strongly objected to the suggestion that non-
contingent deferred loads could act as a substitute for spread-load
12b-1 plans.
The Institute's letter described numerous specific problems
under the proposal, which are discussed further below.
A. Prohibition Against Charging Interest
The Institute commented that the prohibition against
charging interest ignored economic reality and the manner in which
sales charges are financed. In view of the subsequent adoption of
amendments to the NASD's maximum sales charge rules (discussed
below under "Other Developments") that specifically permit interest
to be charged, and that were approved by the Commission, it appears
that this issue may no longer be a problem, so long as the final
rule makes clear that an allowance for interest can be made.
B. Payment and Tax Problems
The etter noted certain problems with the payment of
installment loads. For example, although deducting them from
dividends might be the preferred method, this might not be feasible
in the case of shareholders who have their dividends reinvested,
since the proposed rule would prohibit the imposition of any
deferred load on shares purchased through the reinvestment of
dividends.
Additional problems could result if dividend amounts were not
sufficient to cover the amount of the installment payment. For
example, involuntary redemptions would confuse and upset
shareholders, and might lead to adverse tax consequences (e.g.,
shareholders incurring tax liabilities for gains when not actually
receiving any distributions, or realizing losses; recordkeeping
burdens because each installment payment would be treated as an
increase in the shareholder's basis.)
C. Increased Costs of Individual Account Transactions
The letter stated that the proposed rule's conditions
would necessitate computer redesign and capacity augmentation to
make possible individual shareholder accounting and monitoring. As
a result, the letter asserted, the proposal would create additional
costs for funds and their shareholders, and would substantially
increase transfer agency costs. Broker-dealers would be burdened
by the necessity to maintain detailed records and perform
essentially transfer agency functions in the case of shares held in
street name, the letter indicated.
D. Distributor's Accounting and Recordkeeping Burdens
In addition, the letter noted that non-contingent
deferred load arrangements may pose difficult accounting and
recordkeeping problems for fund distributors, particularly in
complying with Rule 17a-3 under the Securities Exchange Act of
1934. For example, the load due from each shareholder would have
to be reflected as a receivable, but it could be difficult, if not
impossible, to determine the exact amount of the receivable if it
must be calculated on the basis of the lesser of net asset value at
purchase or redemption.
E. Unworkable Conditions
The Institute's letter stated that specific conditions
under the rule raised ambiguities and anomalies demonstrating that
the rule, as proposed, was unworkable. For example, according to
the letter, the prohibition on imposing any deferred load on
amounts representing capital appreciation, combined with the
requirement to assess a deferred load at the lower of purchase or
redemption price, would result in the underwriter receiving a load
based on a lower net asset value than at the time of purchase,
whether the net asset value had appreciated or depreciated.
Finally, the Institute suggested that if the Commission wished
to adopt a non-contingent deferred load option despite all these
problems, the NASD should establish the specific conditions and
standards that would apply, subject to Commission oversight.
Recent Comment Letters
In recent months, several comment letters have been filed
supporting the portion of the Commission's proposal that would
permit installment loads. Generally, these letters urge the
Commission to allow installment load arrangements as an alternative
method of financing the sale of mutual fund shares. The letters,
which are summarized below, represent the views of a bank and its
counsel and one fund group.
In the first letter, the bank's counsel recommends that the
Commission adopt proposed Rule 6c-10, but with clarifications in
three areas. First, the letter asks the Commission to clarify that
all payments under an installment load structure are permitted to
be calculated on the basis of NAV at the time of purchase. Second,
the letter requests clarification that an "implicit interest
charge" comprising a portion of stated deferred sales loads would
be permitted under the rule. Finally, clarification is sought that
deferred sales load arrangements (whether or not interest is
charged) will not be viewed as extensions of credit from the
principal underwriter to the shareholder in violation of Section
11(d)(1) of the Securities Exchange Act of 1934.
In a second letter, at the staff's request, the bank's counsel
analyzes certain tax and ERISA issues raised by the installment
load proposal. These include prohibited transaction and other
concerns in connection with the use of non-contingent deferred
loads in tax-privileged situations such as individual retirement
accounts and tax-qualified retirement plans. The letter expresses
the view that installment load arrangements could be structured so
as to minimize concerns that investors would incur tax liability
for gains when not actually receiving distributions, or would
realize losses. The letter basically concludes that none of the
issues raised should prevent the Commission from adopting the
proposal.
Attached to that letter, a letter from the bank to its counsel
discusses the perceived advantages of installment load arrangements
over distribution arrangements that use a 12b-1 plan, from the
perspective of "financiers to the industry." According to the
letter, such issues as termination risk, the impact of NAV
fluctuations, prudent limits of borrowing and a limited supply of
credit, are absent or minimal in the case of installment loads.
The comment letter of the fund group endorses the letters
described above. It supports permitting installment load
structures as an alternative to existing spread-load structures.
The letter claims that the spread-load structure has been very
popular with shareholders, but that it is difficult for smaller or
independent fund groups to obtain the financing necessary to
support such a structure. The letter asserts that financing would
be more readily available in connection with an installment load
structure because, among other things, it does not involve the
termination risk associated with 12b-1 payments.
Other Developments
The Institute's comment letter on proposed Rule 6c-10 was
filed in January 1989, over five years ago. At that time, proposed
amendments to Rule 12b-1 were pending that, in effect, would have
eliminated spread-load plans. Although those amendments are still
pending, the staff's 1992 report on investment company regulation
recommended that "the Commission adopt only the portions of the
proposed amendments to rule 12b-1 that are consistent with the use
of spread loads." Thus, it no longer appears that installment
loads would be presented as a substitute for spread-load 12b-1
plans, which was a major (if not the primary) concern when Rule 6c-
10 originally was proposed.
Also, effective July 7, 1993, the NASD's Rules of Fair
Practice were amended so that all mutual fund sales charges --
front-end, deferred and asset-based -- are subject to maximum
limits under those rules. The staff's 1992 report had recommended
adoption of the NASD's proposal, and it subsequently was approved
by the Commission. Under the NASD's rules, the limits on total
sales charges for funds with an asset-based sales charge
specifically contemplate an interest component.
Thus, as the Institute had suggested, the NASD has formally
asserted its regulatory authority over all mutual fund sales
charges. In addition, by approving the NASD's amended maximum
sales charge rules, the Commission implicitly has accepted the
premise that a fund underwriter that advances commissions to
brokers and is paid back over time should be compensated (through
interest payments) for the cost of the amounts advanced. It is our
understanding that the staff is aware of the apparent inconsistency
between the prohibition on interest in proposed Rule 6c-10 and the
specific provision for interest in the NASD rules.
Issues for Discussion
Based on the developments described above, it appears that
some of the concerns the Institute raised in 1989 no longer exist.
Nevertheless, if the Commission intends to permit funds to adopt
installment load arrangements, it would be useful to ensure that
the many operational and other technical issues discussed in the
Institute's comment letter, to the extent that they still would be
problems, will be addressed in an appropriate manner in the final
rule.
Thus, in preparation for the discussion at the April 12
meeting, please consider: (1) which issues still would affect the
feasibility of utilizing installment loads, (2) specific
recommendations for addressing these issues, and (3) if the
remaining unresolved issues are numerous and significant, whether
the Institute should urge the Commission to repropose the portion
of its proposal relating to non-contingent deferred loads.
Frances M. Stadler
Associate Counsel
Attachments