On 5 November 2010, the public comment period will come to a close on the US Securities and Exchange Commission's ambitious proposal to reform how payments are made for the distribution of US mutual fund shares. So far the larger industry participants, whether funds or the broker-dealers that sell their shares, have not yet chimed in to any significant degree, but we expect a flurry of comment letters to arrive beginning ofmonth-end.

For 30 years, Rule 12b-1 under the US Investment Company Act of 1940 has regulated the use of fund assets for the distribution of shares to investors. Under that rule and regulatory guidance surrounding it, a fund registered under the Investment Company Act must meet various requirements before the costs of certain distribution and related activities may be considered expenses of the fund.

Yet within those boundaries, industry participants jointly arrived at a system under which Rule 12b-1 deductions from US mutual funds came to pay for a broad-based distribution and service system, supporting an array of broker-dealer distributors, retirement plan administrators, recordkeepers and others. Rule 12b-1 also democratised how funds are bought and sold by allowing investors the choice of paying an upfront sales commission (or load) of several percentage points of the amount invested, an ongoing fee for distribution and shareholder services (typically paid as a Rule 12b-1 fee), or a combination of those or similar cost structures. The rule has thus been critical to supporting the growth of mutual funds as a public investment option in the United States.

With that growth and flexibility, however, has come confusion. The SEC has remarked that investors do not always understand what their Rule 12b-1 fees pay for, or that the fees can operate essentially as a permanent stream of deductions from fund assets over time. Consumer studies cited by the SEC also suggest that some investors do not understand that they are paying these fees at all. For that reason, the SEC proposes both disclosure changes and fee limits. As proposed, what previously were billed as Rule 12b-1 fees would now consist of a fee of up to 0.25% of assets per annum, (still potentially permanent) to be called a "marketing and service fee" and a second, time-limited fee to be called the "ongoing sales charge". The proposal calls for an 18-month transition period and certain grandfathering for existing arrangements that may be required to sunset after several years.

The changes could also include enabling price competition among front-end sales loads charged by brokers. Currently, compensation to a broker for selling a fund's shares must be that described in a registered fund's prospectus. Thus, the commission is not subject to negotiation between a customer and his or her broker. The SEC requests comment on various questions surrounding that concept.

Finally, while the SEC proposes on the one hand to streamline the role of fund boards of directors in this area by scrapping a number of specific board duties under Rule 12b-1, the agency proposes on the other hand to require directors to make annual determinations with respect to the reasonableness, fairness and effectiveness of front-end sales loads and ongoing sales charges. The SEC also describes several specific factors for a board to consider.

Given the centrality of Rule 12b-1 to the US funds industry, these proposals are being watched carefully and, at least by the funds and broker-dealer communities that would be most directly affected, with more than a little trepidation. The current environment also makes the nature of the comments that will come in over the next few weeks especially important. With recent turnover among key SEC staff backers of the proposal, and with the sheer volume of financial reform rulemaking that the agency is being called upon to handle, robust and well-presented statements of concern about the proposal could push the rulemaking "back in the queue" to await agency action behind other priorities. On the other hand, largely supportive comments, or comments that are limited in number and scope, could serve to accelerate the rulemaking across the finish line.