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Investment Management Institute

2017

Volume One

CORPORATE LAW AND PRACTICECourse Handbook Series

Number B-2309

Co-ChairsBarry P. Barbash

Paul F. Roye


38

Rule 12b-1 Plans of Mutual Funds Underlying Variable Insurance Product Separate Accounts (January 11, 2017)

Gary O. Cohen

Carlton Fields Jorden Burt, P.A.

Copyright © 2017. All Rights Reserved

If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.

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RULE 12b-1 PLANS OF MUTUAL FUNDSUNDERLYING VARIABLE INSURANCE PRODUCT

SEPARATE ACCOUNTS

ByGary O. Cohen1

Carlton Fields Jorden Burt, P.A.Washington, D.C.

[email protected]

I. OVERVIEW

The United States Securities and Exchange Commission (“SEC”) has struggled with the regulation and disclosure of life insurance company product pricing, since it began exercising jurisdiction over variable annuity contracts (“VAs”) in the middle 1960s and variable life insurance (“VLI”) in 19752 (together, “variable insurance products”).

This Outline addresses that part of the SEC’s3 struggle having to do with plans adopted by mutual funds underlying life insurance

1 The author has participated in certain of the matters that this Outline addresses and has spoken at other legal conferences on this subject. See infranotes 13, 21, 52, and 104.

2 The history of how the SEC came to regulate life insurance company products is set out in Gary O. Cohen, Nightmares, Square Pegs and the SEC’s Fitting of Life Insurance Company Products and Entities Under the Federal Securities Laws or How I Came to Love the “Ectoplasmic Theory,” in ALI CLE Conference on Life Insurance Company Products 2015, Current SEC, FINRA, Insurance, Tax and ERISA Regulatory and Compliance Issues, ALI CLE Course of Study Materials 407 (2015) and Gary O. Cohen, A Short Telling of the Wacky History of How the SEC Came to Regulate Variable Life Insurance Company Products, The Investment Lawyer, Vol. 23, No. 5 (May 2016); see also Paul J. Mason and Stephen E. Roth, SEC Regulation of Life Insurance Products -- onthe Brink of the Universal,” Conn. L. Rev., Vol. 15 at 505 (1983).

3 Regarding the terminology used in this Outline, references to the “SEC” are to the agency, to the “Commission” are to the Commissioners, and to the “Staff”

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company separate accounts (“underlying funds”) pursuant to Rule 12b-1 (“Rule 12b-1” or “12b-1”) under the Investment Company Act of 1940 (“1940 Act” or “ICA”)4 to cover distribution expenses.

A. Current Situation

The Commission adopted Rule 12b-1 in 1980. However, the Staff, with the apparent authority of the Commission, effectively banned underlying funds from having Rule 12b-1 plans until 1996.

The Staff banned underlying fund Rule 12b-1 plans principally because of a concern that any fund distribution expenses were covered by variable insurance product contract fees and charges (“fees”). If so, Rule 12b-1 plan fees would not be paid for legitimate services and would constitute double-charging of contract owners. This concern bears on the duty of underlying fund directors in approving or continuing Rule 12b-1 plans in compliance with Rule 12b-1’s requirements, as addressed in III., below.

Related concerns include:

the appropriateness of Rule 12b-1 plan fees after the surrender charge period under a variable insurance product has run, as addressed in IV., below;

the appropriateness of Rule 12b-1 plan fees after a life insurance company has ceased offering a variable insurance product, as addressed in IV., below; and

the specific use of Rule 12b-1 plan fees beyond any reference to trail commissions, as addressed in V., below.

are to the staff, including, where appropriate, staff inspectors from the SEC’s Office of Compliance Inspections and Examinations.

4 All references to sections and rules in this Outline are to the Investment Company Act of 1940 and rules thereunder, unless otherwise indicated.

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Last year marked the 20th anniversary of the SEC’s authorization of underlying fund Rule 12b-1 Plans. During that time, there has been significant growth of variable insurance product assets and corresponding underlying fund assets. A large number and variety of underlying funds have developed, providing contract owners with a broad choice of investment objectives and policies.

There are a number of Commission and Staff initiatives that relate to Rule 12b-1 plans, as addressed in VI., below. The Staff has pursued a distribution-in-guise initiative that focused on what constitutes distribution expenses. The Commission has proposed5

an alternative approach to Rule 12b-1 that, among other significant changes, would eliminate the requirement of any finding by fund boards of directors. And the SEC Investor Advisory Committee has submitted a recommendation to the Commission regarding fund cost disclosure.

In addition, the life insurance industry has urged the Commission to adopt a summary prospectus and layered disclosure for VAs, and the SEC has announced that it will consider proposing such a disclosure scheme.

For these reasons, this is an appropriate time to consider how the historical concerns of the Commission and its Staff regarding underlying fund Rule 12b-1 plans have been addressed.

B. Staff Historical Concern

The history of the Staff’s concern can be briefly outlined as follows:

The Staff, after the adoption of Rule 12b-1 in 1980 and with presumed Commission authority, effectively

5 Mutual Fund Distribution Fees; Confirmations, Securities Act Release No. 9128, Securities Exchange Act Release No. 62544, Investment Company Act Release No. 29367 at 85 (July 21, 2010)(proposing “a new rule and rule amendments that would replace rule 12b-1”), available at http://www.sec.gov/rules/proposed/2010/33-9128.pdf [hereinafter SEC Rule 12b-1 Alternative Proposal Release].

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prohibited underlying fund Rule 12b-1 plans for close to 16 years.

The Staff, in 1996 and with presumed Commission authority, reversed itself and permitted underlying fund Rule 12b-1 plans, subject to warnings as to their appropriateness.

During the ensuing 20 years, the Commission and its Staff, from time to time, have questioned the appropriateness of underlying fund Rule 12b-1 plans.

In 2010, for example, the Commission proposed an alternative approach to Rule 12b-1 and raised the question whether “it is appropriate to permit underlying funds to impose the [proposed] marketing and service fee or ongoing sales charges,” “[g]iven that most distribution activities occur at the separate account level.”6

Currently, the Staff may have some concern, perhaps in the context of the Staff’s distribution-in-guise initiative, regarding the process that some underlying fund boards of directors have followed in approving the continuance of underlying fund Rule 12b-1 plans.

C. Commission Contexts for Addressing Underlying FundRule 12b-1 Plans

As noted above, the Commission has proposed an alternative approach to Rule 12b-1 and, in doing so, has raised questions about the appropriateness of underlying funds’ imposing distribution fees. Although more than six and a half years have passed since the proposal, the Commission has not withdrawn the proposal and could take it up again after completing its rule-making required by the Jump Start Our Business Startups Act of

6 Id. at 85.

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20107 and the Dodd-Frank Wall Street Reform and Consumer Protection Act.8

There are, as addressed in VI., below, a number of other pending matters in connection with which the Commission could formally consider its historical concern regarding underlying fund Rule 12b-1 plans, such as:

the Staff’s distribution-in-guise initiative,

the Commission’s proposed alternative approach to Rule 12b-1,

the life insurance industry’s VA summary prospectus and layered disclosure initiative, and

the SEC Investor Advisory Committee recommendation regarding mutual fund prospectus disclosure.

7 Pub. L. No. 112-106, 126 Stat. 306 (Apr. 5, 2012)[hereinafter JOBS Act].

8 Pub. L. No. 111-203, 124 Stat. 1376 (July 21, 2010)[hereinafter Dodd-Frank Act].

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II. SEC HISTORICAL CONCERN WITH UNDERLYING FUND RULE 12b-1 PLANS

A. Timeline

The SEC followed a long path before authorizing retail funds –not to mention underlying funds – to use shareholder assets to pay distribution costs. The timeline is set out below:

May 4, 1976 Investment Company Institute raises issue of use of fund assets for promotional purposes. Investment Company Institute letter to Staff

June 15, 1976 Staff permits fund investment adviser to pay portion of fee to dealers selling shares. Staff no-action letter to Brown, Wood, Ivey, Mitchell & Petty in response to incoming letter of May 14, 1976

July 15, 1976 Staff announces that it is giving active consideration to use of fund assets to pay expenses of distributing fund shares. SEC letter to Investment Company Institute in response to incoming letter of June 29, 1976

October 4, 1976 Commission announces public hearings on arrangements whereby funds bear expenses related to distribution of their shares. SEC ICA Release No. 9470

November 17-23,1976

Commission holds public hearings on arrangements whereby funds bear expenses related to distribution of their shares.

August 31, 1977 Commission announces that it has not changed its previous position that it is generally improper for funds to use their assets to finance the distribution of their shares. SEC ICA Release No. 9915

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May 23, 1978 Commission gives advance notice of proposed rulemaking re funds’ bearing distribution expenses. SEC ICA Release No. 10252

September 7, 1979 Commission proposes rule authorizing Rule 12b-1 plans. SEC ICA Release No. 10862

October 28, 1980 Commission adopts rule authorizing Rule 12b-1 plans. SEC ICA Release No. 11414

October 28, 1980 Rule 12b-1 becomes effective. SEC ICA Release No. 11414

October 28, 1980 Staff effectively bars Rule 12b-1 plans for underlying funds. See SEC ICA Release No. 15586 (February 26, 1987)

September 24, 1986 Commission provides requested information on Rule 12b-1 plans to House Committee on Energy and Commerce. Commission Chairman letter to Committee Chairman

June 13, 1988 Commission proposes amendments to Rule 12b-1, but does not adopt them. SEC ICA Release No. 16431

July 7, 1992 Commission approves amendments to NASD Conduct Rule 2830 effectively limiting the maximum amount of Rule 12b-1 fees under a plan. Securities Exchange Act Release No. 30897

May 30, 1996 Staff reverses itself and permits Rule 12b-1plans for underlying funds. Staff letter to industry associations

January 1, 1997 National Securities Markets Improvement Act of 1996 Act becomes effective, amending the 1940 Act to impose a reasonableness standard for aggregate variable insurance product contract fees. Pub. L. 104-290, 110 Stat. 3416 (October 11, 1996)

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February 24, 2004 Commission proposes amendment to Rule 12b-1 to prohibit funds from paying for distribution of fund shares with brokerage commissions, inviting comment on whether the Commission should consider additional changes to the rule, including potentially rescinding it. SEC ICA Release No. 26356

May 18, 2004 Commission releases Staff study on the costs and benefits to fund shareholders of Rule 12b-1 plans. SEC Today, Volume 2004-96

September 2, 2004 Commission adopts amendment to Rule 12b-1 to prohibit funds from paying for distribution of fund shares with brokerage commissions. SEC ICA Release No. 26591

June 19, 2007 Commission holds Roundtable on Rule 12b-1 to discuss, among other things, options for reform or rescission of Rule 12b-1. SEC Press Release No. 2007-112, dated June 12, 2007

July 21, 2010 Commission proposes alternative approach to Rule 12b-1. SEC ICA Release No. 29367

B. Staff Recognized Insurance Industry Distribution Costs

The Staff has long recognized that life insurance companies are under pressure to cover distribution costs. The Staff, for example, stated in 1996 that it had received reports that “insurance companies are increasingly seeking financial and other assistance to cover their costs associated with indirectly marketing [underlying] fund shares to [variable insurance product] contract owners.”9

9 Letter from Heidi Stam, Associate Director, SEC Division of Investment Management, to Gary E. Hughes, Chief Counsel, Securities and Banking,

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Life insurance companies may want underlying fund Rule 12b-1 plans, because, among other things, marketing considerations create pressure to move fees from the life insurance company level to the underlying fund level. The financial press, when comparing the costs of competing variable insurance products, historically has focused on the product contract fees, such as the mortality and expense risk assumption charges, rather than underlying fund fees. This has created downward pressure on fees for mortality and expense risk guarantees and the imposition of Rule 12b-1 plan fees at the underlying fund level. The situation can be said to be similar to that in the restaurant business, where the press, with limited space, compares the costs of entrees, leading restaurants to raise the cost of appetizers, drinks, and desserts instead of entrees.

However, the Commission has countered any such practice with requirements for variable insurance product prospectus disclosure of underlying fund fees.

For example, the Commission’s Form N-4 Registration Statement under the 1940 Act for unit investment trust separate accounts offering variable annuity contracts requires disclosure of the:

Total annual [Portfolio Company] Operating Expenses(expenses that are deducted from [portfolio company] assets, including management fees, distribution [and/or service](12b-1) fees, and other expenses).10

American Council of Life Insurance, Paul Schott Stevens, General Counsel, Investment Company Institute, and Mark J. Mackey, President & Chief Executive Officer, National Association for Variable Annuities 2 (May 30, 1996), available at www.sec.gov/divisions/investment/noaction/1996/hughes-acli052696.pdf[hereinafter SEC Staff Reversal Letter]. The Staff’s statement was in the context of an independent money management firm establishing mutual funds as underlying funding media for VAs and VLI products presumably issued by more than one unaffiliated life insurance company. Id. The reports that the Staff referenced presumably were received during the years that the Staff’s ban was in effect.

10 Form N-4, Item 3(a) (emphasis added).

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The Staff has stated as follows regarding disclosure in a separate account prospectus:

The Division also expects that insurance company sponsors of variable contracts will fully disclose any rule 12b-1 fees of an underlying fund in the prospectus for the separate account. Disclosure in the separate account prospectus should communicate clearly to investors in one place the combined effect of all fees and charges, including rule 12b-1 fees, imposed by the separate account and the underlying fund. The Division intends to give particular scrutiny to disclosure of rule 12b-1 fees in its review of separate account registration statements filed with the Commission.11

C. Staff Banned Underlying Fund Rule 12b-1 Plans

Notwithstanding the Staff’s recognition of industry distribution costs, the Staff, with presumed Commission authority, did not permit underlying funds affiliated with life insurance companies to adopt 12b-1 plans for close to 16 years after the Commission’s adoption of Rule 12b-1.

The then Director of the Division of Investment Management and his successors took the position that the mortality and expense risk assumption charge under a VA was designed to cover the distribution costs of the product which included the underlying fund shares.12 So, Rule 12b-1 plan fees at the underlying fund

11 SEC Staff Reversal Letter, supra n.9 at 3 (emphasis added).

12 The Commission, in proposing its Rule 12b-1 alternative proposal in 2010, quoted a statement made by Joel Goldberg, who was the Director of the SEC’s Division of Investment Management at the time the Commission adopted Rule 12b-1, as follows:

While variable insurance products, like mutual funds, did not paydistribution fees prior to the adoption of rule 12b-1, they paid mortalityand expense charges. These provided a source of revenue to reimbursethe insurance company for the portion of the sales commission notcovered by a CDSL.

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level would necessarily duplicate fees for distribution at the product level and therefore be excessive.

The Staff imposed the ban by what was then called “administrative muscle.” The Staff, in processing underlying fund filings of registration statements or post-effective amendments, would give the comment that Rule 12b-1 plans were not permitted. Registrants would comply with the comment in order to achieve effectiveness of the filings under the Securities Act of 1933.

However, the Staff’s ban on Rule 12b-1 plans did not apply to underlying funds that offered and sold their shares to separate accounts of various “unaffiliated” life insurance companies.13 The Commission took the position14 that such funds would incur promotional and other distribution expenses that would not be incurred by an underlying fund affiliated with, and selling shares to, an individual life insurance company. The Commission stated that:

it would appear that a 12b-1 plan is far more justified in the case of a fund whose shares are sold to separate accounts of unaffiliated insurance companies than for a fund whose shares are sold to the separate accounts of a

SEC Rule 12b-1 Alternative Proposal Release, supra note 5, at 84 n.257 (citing Joel H. Goldberg and Gregory N. Bressler, Revisiting Rule 12b-1 under theInvestment Company Act, in 31 SEC. & COMMODITIES REG. REV. 147 n.28 (1998)).

13 For a discussion of such Rule 12b-1 plans, see Gary O. Cohen, Joint Ventures: Structuring the Basic Relationship Between Life Insurance Company and Unaffiliated Mutual Funds, in ALI-ABA Conference on Life Insurance Company Products, Current Securities and Tax Issues, ALI-ABA Course of Study Materials 177 (1989). Because of the Commission’s position, this Outline focuses on underlying funds that do not offer and sell their shares to various life insurance companies that are not affiliated with each other.

14 Payment of Asset-Based Sales Loads by Registered Open-End Management Investment Companies, Investment Company Act Release No. 16431 at 88 n.164 (June 13, 1988), 53 Fed. Reg. 23258 (June 21, 1988), available athttp://cdn.loc.gov/service/ll/fedreg/fr053/fr053119/fr053119.pdf [p. 64. of PDF], (proposing amendments to Rule 12b-1 that the Commission did not adopt).

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single company or to separate accounts of affiliated companies.15

D. Commission and Staff Expressed Continuing Concern

The Commission and its Staff expressed their continuing concern in the years following the Commission’s adoption of Rule 12b-1.

1. Commission Concept of Underlying Fund Distribution Expenses

In 1987, the Commission proclaimed that an underlying fund did not have much need for a 12b-1 plan, stating:

Where an underlying fund sells its shares exclusively to the separate accounts of an affiliated insurance company as an investment vehicle for variable insurance contracts issued by the company, there appears little need for a 12b-1 plan; few distribution expenses are necessary for such a “captive” fund to sell its shares to the trust account.16

The Commission said that directors should carefully consider the “propriety of a 12b-1 plan and the potential for double-charging investors at the separate account level for distribution costs of the underlying fund.”17

15 Id. (emphasis added).

16 Exemptive Relief for Variable Annuity and Flexible Premium Variable Life Insurance Separate Accounts Relating to Deduction of Certain Charges from Account Assets, Investment Company Act Release No. 15586 at 28 (Mar. 9, 1987), 52 Fed. Reg. 7166-01 (March 9, 1987), available athttp://cdn.loc.gov/service/ll/fedreg/fr052/fr052045/fr052045.pdf [p. 72. of PDF], (reproposing Rule 26a-3)(emphasis added).

17 Id.

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2. Commission Proposed Amendment to Rule 12b-1

In 1988, the Commission proposed18 to amend Rule 12b-1. In doing so, the Commission, without expressly referring to the ban on underlying fund Rule 12b-1 plans, indicated its continuing concern that underlying Rule 12b-1 were not justified, as follows:

In the context of a fund that is an investment vehicle for insurance products, the “surrounding circumstances” that directors must consider in approving a 12b-1 plan include the existence and level of any mortality or expense risk charge imposed on contractholders to the extent such charge may be used, directly or indirectly, to pay for distribution.19

3. Staff Inspection Manual

The Staff reflected its concern in its inspection manual as follows:

Rule 12b-1 Plans. Examiners should contact OIP [i.e., the Division of Investment Management’s Office of Insurance Products] whenever they encounter management accounts or underlying funds that have adopted 12b-1 plans Directors of management accounts or underlying funds, when adopting or approving plans of distribution under Rule 12b-1, should always review and consider all the fees and charges associated with each VLI [i.e., variable life insurance] and/or variable annuity contract issued in connection with the account or fund.20



20 SEC, Investment Company Examination Manual, Supplement for Variable Insurance Products and Insurance Company Separate Accounts 47 (Jan. 1989) (underlined emphasis in original; bold emphasis added).

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E. Staff Permitted Underlying Fund Rule 12b-1 Plans but Stated Concern

1. Staff Reversed Ban

But in 1996, almost 16 years after the Staff banned underlying fund Rule 12b-1 plans, the Staff, with the likely authority of the Commission, reversed the ban.21

The Staff sent a letter22 to the industry totally reversing the Staff’s position and agreeing with what the industry had argued all along – that underlying fund Rule 12b-1 plans were consistent with the 1940 Act.

The Staff said:

In the Division’s view, no provision of the Investment Company Act precludes a mutual fund that serves as an investment vehicle for a variable insurance separate

21 For a discussion of the impact of the SEC’s reversal of the ban on Rule 12b-1 plans for underlying funds over the ensuing years, see Gary O. Cohen, “Revenue Sharing” by Mutual Funds with Life Insurance Companies Pursuant to Rule 12b-1 Plans and Administrative Services Arrangements, in ALI-ABA Conference on Life Insurance Company Products: Current Securities, Tax, ERISA, and State Regulatory Issues, ALI-ABA Course of Study Materials 139, 153 (1998); Gary O. Cohen, Rule 12b-1 Plans of Mutual Funds Underlying Variable and Variable Life Insurance Separate Accounts of Life Insurance Companies, in Practicing Law Institute, The Investment Management Institute (1999); Gary O. Cohen, Defining the Role and Duties of Underlying Mutual Fund Directors in Light of Recent Regulatory, Judicial and Industry Developments, in ALI-ABA Conference on Life Insurance Company Products: Current Securities, Tax, ERISA and State Regulatory Issues, ALI-ABA Course of Study Materials 1, 23 (2001); and Gary O. Cohen, SEC, Congressional, and Judicial Developments Involving Charges Imposed Under Variable Annuity Contracts, Variable Life Insurance Policies, and Underlying Mutual Funds, inALI-ABA Conference on Life Insurance Company Products: Current Securities, Tax, ERISA, and State Regulatory Issues, ALI-ABA Course of Study Materials 1, 34 (2003).

22 SEC Staff Reversal Letter, supra note 9. Although the letter was signed by the Staff, it is likely that the Staff would not have taken such an important policy position without authority from the Commission.

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account . . . from adopting and implementing a 12b-1plan.23

The Staff elaborated as follows:

[T]he Division concluded that neither Section 12(b) of the Investment Company Act nor rule 12b-1, nor any other provision of the Investment Company Act or rules thereunder, prohibits the use of 12b-1 plans in connection with variable insurance contracts or otherwise treats underlying funds differently from other mutual funds. Consistent with rule 12b-1, the responsibility for determining whether a particular 12b-1 plan is beneficial to an underlying fund and contract owners rests with the fund’s board of directors.24

2. Staff Expressed Concern

At the same time that the Staff lifted the ban on underlying fund Rule 12b-1 plans, the Staff expressed concern.

First, the Staff emphasized the general duty of underlying fund directors to comply with the requirements of Rule 12b-1, as follows:

[T]he Division is concerned that the unique offering structure and hybrid nature of variable insurance contracts may complicate investor understanding of the use and effect of 12b-1 plans in this context. The Division therefore wishes to emphasize the responsibility of underlying fund boards of directors and insurance company sponsors to ensure that all regulatory and disclosure requirements pertaining to a

23 Id. at 2.

24 Id.

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12b-1 plan are satisfied when an underlying fund seeks to adopt such a plan.25

The Staff did not articulate its concern using the Commission’s long-standing terms of whether underlying fund Rule 12b-1 plans duplicate fees imposed under the variable insurance product contract at the separate account level. Instead, the Staff articulated its concern using terms of assuring that contract owners benefit from the Rule 12b-1plans, as follows:

A 12b-1 plan for an underlying fund must comply with all of the requirements of rule 12b-1, including director and shareholder approval requirements. Specifically, underlying fund directors are required to decide, in the exercise of their reasonable business judgment and in light of their fiduciary duties, that there is a reasonable likelihood that the 12b-1 plan will benefit the fund and its shareholders.26

The Staff specified the underlying fund directors’ duty to assure that contract owners would benefit, as follows:

Directors should assure themselves in each case that legitimate services will be rendered in return for payments under the 12b-1 plans.27

This language did not specifically refer to duplication of distribution fees at the underlying fund and separate account levels. However, it implicitly referred to such duplication, in that it would be difficult for underlying fund directors to claim that shareholders received “legitimate services” for the Rule 12b-1 fees, if such fees duplicated distribution fees charged

25 Id.



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under the variable insurance product contract at the separate account level.

The Staff also made clear that underlying fund directors had the duty to consider the benefit to fund shareholders in terms of the benefit to contract owners rather than the life insurance company separate accounts, as follows:

The Division further emphasizes that, in the context of a two-tiered variable insurance offering, the finding of benefit to fund shareholders requires the likelihood of a benefit to the individual contract owners, not the insurance company separate account, which is the technical owner of the fund’s shares. Consistent with that approach, variable insurance contract owners, rather than separate accounts, must give any shareholder approval required by rule 12b-1.28

Notwithstanding the foregoing, the Staff seemed to stop short of requiring that underlying fund directors actually evaluate or analyze variable insurance product contract fees. As an industry executive observed:

The Interpretive Letter seems to place a heavy burden on the board of the insurance product fund. Not only must the board make the findings generally associated with the adoption of a 12b-1 plan, but it must also determine that (i) the plan will benefit the individual contract holders, and (ii) “legitimate services” will be rendered in return for the 12b-1 fee paid. A question that the Interpretive Letter does not address is to what degree must the board evaluate variable contract sales charges and mortality and expense fees and their use in financing distribution efforts in making the necessary determinations that a 12b-1 plan should be implemented. Again, there is some debate as to how in-depth the board should review and evaluate insurance company fees and charges, although most

28 Id. at 2-3.

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agree that the board should takes [sic] these fees into account to some degree.29

3. Former Staff Members

Former Staff members, speaking on their own, have made statements regarding the duty of underlying fund directors to evaluate variable insurance product contract fees.

A former member of what was then named the Office of Insurance Products has stated that “in evaluating a 12b-1 plan, [underlying] insurance fund directors cannot ignore the activities of insurance companies in distributing the variable contracts supported by their funds or the role that contract fees play in financing those activities.” 30

However, a former chief of that Office of Insurance Products has pointed out a problem with the foregoing position in the context of underlying funds that are otherwise unaffiliated with life insurance companies and offer their shares to more than one life insurance company. He stated that “requiring an Underlying Fund’s board to review contract and separate account charges and profitability might be impractical in the case of an Underlying Fund used in a mixed and shared funding context, since the charges and anticipated profits would differ for each insurance company.”31

F. Commission Factors

29 Robert M. Zakem, Senior Vice President and General Counsel, SunAmerica Asset Management Corp., Distribution Plans for Mutual Funds Underlying Variable Insurance Products 7 (1999) (emphasis added, footnotes omitted) (referring to the SEC Staff Reversal Letter, supra note 9) (paper in author’s files).

30 David S. Goldstein, Distribution Plans for Mutual Funds Supporting Variable Insurance Products, The Investment Lawyer, Vol. 3, No. 11 at 3 (Nov. 1996)(emphasis added).

31 W. Randolph Thompson, Use of Rule 12b-1 Plans by Underlying Funds, inALI-ABA Conference on Life Insurance Company Products: Current Securities, Tax, ERISA, and State Regulatory Issues, ALI-ABA Course of Study Materials 33 (Nov. 1996)(emphasis added).

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The Commission, in adopting Rule 12b-1, specified the following list of factors32 that “would normally be relevant”33 to a determination by fund directors to use fund assets for distribution:

the need for independent counsel or experts;

the nature and causes of problems or circumstances purportedly making a Rule 12b-1 plan necessary or appropriate, including: (i) the anticipated expenditures and their relationship to the fund’s overall cost structure and (ii) the nature and timing of anticipated benefits;

alternative plans;

the interrelationship between a Rule 12b-1 plan and the activities of any other person who finances distribution of

32 The SEC originally proposed that the text of Rule 12b-1 set out the factors. See Investment Company Act Release No. 10862 (Sept. 7, 1979)(proposing Rule 12b-1). However, the SEC ultimately decided that Rule 12b-1 should not set out the factors, but, rather, should include a note within the text of Rule 12b-1 that refers to the list of factors set out in the adopting release. See Investment Company Act Release No. 11414 (Oct. 28, 1980)(adopting Rule 12b-1). The note reads as follows:

For a discussion of factors which may be relevant to a decision to use company assets for distribution, see Investment Company Act Releases Nos. 10862, September 7, 1979, and 11414, October 28, 1980.

The SEC explained its change of approach regarding the factors as follows:

We originally included the factors in the text of the rule when weproposed it for public comment. . . . In order to avoid the appearance ofeither unduly constricting the directors’ decision-making process or ofcreating a mechanical checklist, we deleted the list of factors from rule12b-1 at its adoption. Although we decided not to require the directorsto consider any particular factors, the adopting release noted that theenumerated factors “would normally be relevant to a determination ofwhether to use fund assets for distribution.”

SEC 12b-1 Alternative Proposal Release, supra note 5, at 15 n.49.

33 Bearing of Distribution Expenses by Mutual Funds, Securities Act Release No. 6254, Investment Company Act Release No. 11414 at 30 (Oct. 28, 1980), 21 SEC Docket 324 (1980). (adopting Rule 12b-1).

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the fund shares, including whether fund payments to the other person are made in such a manner as to constitute the indirect financing of distribution;

the possible benefits to any other person relative to those expected for the fund; and

the effect of the Rule 12b-1 plan on existing shareholders; and in the context of continuing a Rule 12b-1 plan, whether the plan, in fact, has produced the anticipated benefits.34

One of the factors is “the interrelationship between the plan and the activities of any other person who finances . . . distribution of the [fund’s] shares.”

The language is ambiguous in the context of underlying funds. The language “any other person” conceivably can be read to mean a life insurance company. Under that reading, an underlying fund would be required to disclose the relationship between its Rule 12b-1 plan and the activities of a life insurance company whose variable insurance product invests in the fund. In theory, this reading could implicate the fees imposed under a life insurance company’s variable insurance product contract.

If the Commission so intends, the Form N-1A Registration Statement disclosure requirement, addressed immediately below, is still a further reflection of the Commission’s concern that an underlying fund Rule 12b-1 plan fee might duplicate fees imposed under a life insurance company variable insurance product contract.

34 Id.

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G. Form N-1A Registration Statement

The Commission’s Form N-1A Registration Statement requires disclosure in the Statement of Additional information that is relevant to underlying fund Rule 12b-1 plans.

Item 19(g) requires that, “[i]f the fund has adopted a plan under rule 12b-1, describe the material aspects of the plan, and any agreements relating to the implementation of the plan” and lists specific aspects to disclose.

One of the aspects required to be disclosed is:

Whether the Fund participates in any joint distribution activities with another . . . investment company. If so,disclose, if applicable, that fees paid under the Fund’s rule 12b-1 plan may be used to finance the distribution of the shares of another . . . investment company, and state the method of allocating distribution costs (e.g., relative net asset size, number of shareholder account).

The foregoing language can be read to apply, on a horizontal basis, to an underlying fund and its sister funds or, on a vertical basis, to an underlying fund and the registered separate accounts that invest in the fund.

H. Judicial Considerations

It is beyond the scope of this Outline to provide an overall survey of litigation regarding Rule 12b-1. However, it is relevant to note that, while an implied private right of action likely does not lie under Rule 12b-1, the courts have found that the express private right of action in Section 36(b) applies to Rule 12b-1 fees.

1. Implied Private Right of Action

The Courts have not had much opportunity to pass upon the appropriateness of Rule 12b-1 plans generally, much less the appropriateness of underlying fund Rule 12b-1 plans.

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Consequently, the courts have little to contribute to the issue that this Outline addresses.

The U.S. Supreme Court, in 2001, held35 that no implied private right of action existed under certain regulationspromulgated under federal civil rights law. In doing so, the Supreme Court proclaimed a stringent analytical test that has led lower courts to deny allegations of implied private rights of action under federal statutes, including the 1940 Act.36

It follows that courts probably would be reluctant to find an implied private right of action under Rule 12b-1.

2. Express Private Right of Action

a. Section 36(b)

At the same time, courts have found that the express private right of action granted by Section 36(b) of the 1940 Act extends beyond investment advisory fees to distribution fees under Rule 12b-1 plans. As one court has

35 Alexander v. Sandoval, 523 U.S. 275, 286 (2001).

36 See, e.g., Bellikoff v. Eaton Vance Corp., 481 F.3d 110 (2d Cir. 2007)(no implied private right of action under Sections 34(b), 36(a), and 48(a) regarding breaches of duty and failure to disclose so-called “shelf space” payments); Stegall v. Ladner, 394 F. Supp. 2d 358, 371 (D. Mass. 2005) (no implied private right of action under Section 34(b) regarding misstatements in prospectuses and reports); Mutchka v. Harris, 373 F. Supp. 2d 1021, 1026-1027 (C.D. Cal. 2005) (no implied private right of action under Section 36(a) regarding fiduciary duty); In re Merrill Lynch Global Technology Fund Securities Litigation, Master File 02-CV-MDL-1484 (S.D.N.Y. 2003) (no implied right of action under Section 34(b) for misstatements in prospectuses and reports); Olmsted v. Pruco Life Ins. Co., 283 F.3d 429 (2d Cir. 2002) (no implied private right of action under Sections 26(f) and 27(i) requiring variable insurance product contracts to have reasonable aggregate fees). But see Northstar Financial Advisors, Inc. v. Schwab Investments, No. C 08-4119 SI, 2009 WL 415616 (N. D. Cal., Feb. 19, 2009) (implied private right of action under Section 13(a) regarding deviation from certain fund investment policies).

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ruled, “the costs of 12b-1 plans involving such affiliates . . . are subject to review under Section 36(b).”37

Section 36(b) provides, with emphasis added, that:

The investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser. An action may be brought under this subsection by the Commission, or by a security holder of such registered investment companyon behalf of such company, against such investment adviser, or any affiliated person of such investment adviser, or . . . [an officer, director, member of any advisory board, investment adviser, or depositor, or principal underwriter] who has a fiduciary duty concerning such compensation or payments, for breach of fiduciary duty in respect of such compensation or payments paid by such registered investment company or by the security holders thereof to such investment adviser or person.

The express right of action under Section 36(b) is limited in certain ways, such as:

although a plaintiff need not allege or prove that a defendant engaged in personal misconduct, the plaintiff has the burden of proving a breach of fiduciary duty;38

37 Meyer v. Oppenheimer Management Corp, 895 F2d 861, 866 (2d Cir. 1990) [hereinafter Meyer].

38 Section 36(b)(1).

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fund board of directors approval of a Rule 12b-1plan is not conclusive, and a court need only consider such approval to the extent that the court deems appropriate under all of the circumstances;39

a plaintiff cannot bring an action against any person other than the recipient of the Rule 12b-1plan fee;40

a plaintiff cannot recover damages for any period prior to one year before the action was brought;41

and

a plaintiff can recover only actual damages resulting from the breach of fiduciary duty and that amount cannot exceed the amount of compensation received from the fund.42

b. Court Determinations

The courts have found as follows:

an individual can bring an action on the ground that a Rule 12b-1 plan fee is excessive;43

like an investment advisory fee, a distribution fee, such as a Rule 12b-1 plan fee, is excessive if it is so disproportionately large that it bears no reasonable relationship to the services rendered



41 Id.

42 Id.

43 Pfeiffer v. Bjurman, Barry & Assocs., No. 03 Civ. 9741 (DLC), 2004 WL 1903075, at 4 (S.D.N.Y. Aug. 26, 2004).

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and could not have been the product of arm’s length bargaining;44 and

a court will hold fund directors to the fiduciary standards under Section 36 when they consider whether to implement or continue a Rule 12b-1plan.45

The foregoing does not mean, however, that a court will add Rule 12b-1 plan fees to an investment advisory fee to determine whether a lawsuit brought under Section 36(b) is well-founded. As one court stated:

In Meyer II, we stated that “[a] claim that payments made under Rule 12b-1 are excessive when combined with advisory fees, where both payments are made to ‘affiliated persons’ of an investment adviser, is cognizable under section 36(b).” 764 F.2d at 83. This statement stands only for the proposition that the costs of 12b-1 plans involving such affiliates as well as advisory fees are subject to review under Section 36(b). Weresuch review not available, investment advisers might be able to extract additional compensation for advisory services by excessive distributions under a 12b-1 plan. The statement does not, however, stand for the additional proposition that 12b-1 payments to an adviser’s affiliates are to be aggregated with advisory fees to determine the merits of a Section 36(b) claim. The two kinds of payments are for entirely different services, namely advice on the one hand and sales and

44 Chill v. Calamos Advisors and Calamos Financial Services, 15 Civ. 1014 (ER) (S.D.N.Y. March 28, 2016), citing Jones v. Harris Associates, 559 U.S. 335,344 (2010), citing Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923, 928 (2d Cir. 1982) (suit alleging breach of fiduciary duty regarding compensation received by defendants for investment advisory and distribution services provided to a fund).

45 Krinsk v. Fund Asset Management, Inc. 875 F.2d 404, 412 (2nd Cir. 1989).

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distribution on the other. If the fee for each service viewed separately is not excessive in relation to the service rendered, then the sum of the two is also permissible.46

In March 2015, a court denied47 a motion to dismiss in a lawsuit alleging breach of fiduciary duty regarding compensation received by defendants for investment advisory and distribution services provided to a fund.

Plaintiffs alleged,48 among other things, that:

the Rule 12b-1 fees were excessive because they were pegged to the fund’s assets under management rather than exclusively reflecting actual distribution services;

assets generated in part by the Rule 12b-1 fees had created economies of scale that have not been used to reduce investment advisory fees;

assets under management had shrunk significantly implying low quality and unsuccessful distribution services;49

the fund had discontinued new sales of one share class to new investors for many years, yet still paid Rule 12b-1 plans for distribution services; and

46 Meyer, 895 F.2d at 866 (underlined emphasis in original). The Court’s reference to “Meyer II” is to Meyer v. Oppenheimer Management Corp, 764 F2d 76, 83 (1985).

47 Calamos, 15 Civ. 1014 (ER) at 41.

48 Id. at 38-39.

49 The Court said that this allegation was “somewhat inconsistent” with the preceding allegation. Id. at 38.

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the fund’s Rule 12b-1 plan did not impose fees on the institutional share class, demonstrating that institutions refused to pay Rule 12b-1 fees because the services were of little value.

The Court determined that “[i]f all of these allegations are taken as true, it is sufficiently plausible that the Distribution Fees are significantly in excess of the actual services being provided.”50

50 Id. at 39 (cited precedents omitted).

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III. QUESTION OF DIRECTOR EVALUATION OF PRODUCT CONTRACT FEE

A. Question Raised

To what extend should underlying fund directors take into account the fees imposed under variable insurance product contracts, i.e., the fees at the separate account level? And to what extent must life insurance companies sponsoring underlying funds provide information to the directors about these contract fees?

Typically, directors look at the dollar amount paid out of fund assets and the dollar amount paid for distribution expenses (such as trail commissions), prospectuses and promotional materials, and servicing contract owners.

But should directors also consider the fact that contract owners pay additional fees under the product, these charges are designed into the contract during the product design phase, and, in designing contracts, actuaries project the profitability of a contract, given the known expenses and sources of revenue, which include the fees at both the underlying fund and the separate account levels?

The answer is arguably no, based on the facts and circumstances set out below.

B. SEC Rule 140 Shows that Underlying Funds Are Making Public Offerings

From the outset, the Commission has required both life insurance company separate accounts and underlying funds to register as investment companies.

The Commission’s rationale has been that a life insurance company separate account is making a public offer of separate account interests and the underlying fund is making a simultaneous, but different, public offer of fund shares.

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This concept is based on a long-standing Commission rule --Rule 140 under the Securities Act of 1933 -- that says:

a person, the chief part of whose business is buying securities of an issuer

and the sale of its own securities to provide the money to do so

is distributing securities of the issuer.

This means that a separate account buying shares of an underlying fund with proceeds from the sale of its interests is distributing securities of the underlying fund at the same time that it is distributing its own interests.

Two distributions are happening at the same time. Two sets of distribution expenses are being incurred at the same time.

The clearest example of the two separate distributions is the fact that the SEC requires the life insurance company separate account and the underlying fund each to have its own registration statement and prospectus.

The Staff, in reversing the 16-year ban on underlying fund Rule 12b-1 plans, did not expressly refer to Rule 140. However, the Staff, in effect, referred to Rule 140 by referring to costs associated with “indirectly marketing fund shares to contract owners.”51

51 SEC Staff Reversal Letter, supra note 9, at 2.

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C. Congress Requires that Life Insurance Companies Determine Fee Reasonableness

1. Statutory Requirement

Section 26(f), in effect, makes it lawful for a life company to sell separate account interests under variable insurance products only if the fees deducted under the contract, in the aggregate, are reasonable in relation to the services rendered, expenses expect to be incurred, and risks assumed by the life insurance company, and the company so represents in its registration statement filed with the SEC

Section 26(f) provides in relevant part and with emphasis added:

(2) LIMITATION ON SALES. -- It shall be unlawful for any registered separate account funding variable insurance contracts, or for the sponsoring insurance company of such account, to sell any such contract --

(A) Unless the fees and charges deducted under the contract, in the aggregate, are reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the insurance company, and . . . the insurance company so represents in the registration statement for the contract . . . .

* * * *

(3) FEES AND CHARGES. -- For purposes of paragraph (2), the fees and charges deducted under the contract shall include all fees and charges imposed for any purpose and in any manner.

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Congress added this requirement52 to the 1940 Act in 1996, just a few months after the SEC reversed its 16-year ban on underlying fund Rule 12b-1 plans.

The SEC has not adopted any rule under Section 26(f)(2) and has not brought any public enforcement action under the Section.

2. Staff Recommendation

The approach that Congress followed in enacting Section 26(f)(2) was recommended by the Staff, as follows:

The Division [of Investment Management] recommends that the Commission propose legislation to amend sections 26 and 27 to exempt variable insurance contracts from the specific charge limitations under those provisions, and instead create restrictions against unreasonable aggregate fees.53

The Staff’s rationale for the recommendation was that it was difficult and problematic for the SEC to regulate variable insurance product fees. As the Staff stated:

The Division believes that the proposed amendments to sections 26 and 27, together with improved disclosure, will resolve significant problems

52 For a detailed discussion of the bill that became the statutory requirement, see Gary O. Cohen, Regulation of Charges Under Legislation Regarding Variable Annuity Contracts and Variable Life Insurance, in ALI-ABA Conference on Life Insurance Products: Current Securities, Tax, ERISA, and State Regulatory Issues, ALI-ABA Course of Study Materials 327 (1996).

53 SEC Division of Investment Management, Protecting Investors: A Half Century of Protecting Investors 417 (May 1992). The Commission, without public explanation, decided not to follow its Staff’s recommendation to ask Congress for legislation. However, Texas Congressman Jack Fields, some years later, picked up the Staff’s recommendation and caused it to be enacted into law.

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associated with the regulation of variable insurance charges under the Investment Company Act . . . .”54

The Staff explained the significant problems of regulating variable insurance product fees. To begin with, the Staff pointed out that “[t]he products themselves are extremely complex,”55 do “not fit neatly within the Investment Company Act,”56 and “the regulations applicable to periodic payment plans are in many ways ill-suited for variable insurance.”57

The Staff went on to explain as follows:

A major concern for the Commission is the continuing need to separate “insurance-related” charges from “securities-related” charges and subject only the latter to comprehensive periodic payment plan regulation. With the enactment of the McCarran-Ferguson Act in 1945, Congress determined that regulation of the insurance industry was the exclusive prerogative of the states. Primarily for this reason, the Commission seeks to focus its regulatory efforts exclusively on the securities elements of variable insurance products and to avoid regulation of the insurance elements. Securities-related charges and insurance-related charges, however, cannot be neatly divided for regulatory purposes Some charges that the industry characterizes as insurance charges appear to have components that should be subject to Investment Company Act regulation. Further, so long as the Commission regulates only “investment-related” charges, insurance companies may evade charge limits by adjusting “insurance-related” or unregulated charges to the extent permitted by state law. These


55 Id. at 373.

56 Id. at 374.

57 Id. at 375.

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problems are compounded by significant differences in the degree of insurance protection provided by variable life insurance and variable annuities. 58

It arguably follows that if the Commission and its Staff encountered “significant problems” regulating variable insurance product fees, it would not be practical for underlying fund directors to be required to evaluate the cost structure of variable insurance product contracts.

3. Commission Implementation of Congressional Mandate

The Commission expressly requires a life insurance company to make the reasonableness representation in the Form N-6 Registration Statement for VLI as follows:

Provide a representation of the Depositor that the fees and charges deducted under the Contracts, in the aggregate, are reasonable in relation to the services rendered, the expenses expected to be incurred, and the risks assumed by the Depositor.59

4. Director Reliance

If underlying fund directors have some duty to consider whether Rule 12b-1 plan fees duplicate variable insurance product contract fees, the directors should be able to rely on the reasonableness representation that Section 26(f) requires life insurance companies to make about contract fees.

As addressed above, Section 26(f), in effect, makes it unlawful for a life company to sell separate account interests unless the fees and charges deducted under a variable insurance product contract, in the aggregate, are reasonable in

58 Id. at 377 (emphasis added; footnotes omitted).

59 SEC Form N-6 Registration Statement Under the Securities Act of 1933 and Investment Company Act of 1940, Item 33.

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relation to the services rendered, expenses expected to be incurred, and risks assumed by the company and the company so represents in its registration statement filed with the SEC.

Contract fees would not be reasonable if they duplicated underlying fund Rule 12b-1 plan fees. So, underlying fund directors arguably could fulfill their duty to consider whether plan fees are for legitimate services and do not double-charge contract owners by reviewing the life insurance company’s representation that Congress requires.

D. Directors Might Well Find It Necessary To Have Actuaries on the Board or as Experts

If underlying fund directors are deemed to have a duty to review, analyze and evaluate the cost structure of variable insurance product contracts, focusing on such details as persistency rates, they would have to consider whether to have actuarial experts on their boards of directors (as discussed in 1., below) or hire actuarial experts as outside experts (as discussed in 2., below).

1. Actuary as Director

The obvious question that comes to mind is whether underlying fund boards of directors would need to add actuaries as members.

a. Financial Expert

The Commission currently does not require that fund boards of directors have accountants as members. However, the Commission requires60 funds to disclose, in connection with annual and semi-annual reports to shareholders, whether or not they have financial experts as board members.

60 SEC Form N-CSR, Certified Shareholder Report of Registered Management Investment Companies, Item 3.

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The Commission defines “financial expert” to mean a person who has

an understanding of generally accepted accounting principles and financial statements;

the ability to assess the general application of such principles in connection with the accounting for estimates, accruals, and reserves; and

experience preparing, auditing, analyzing, or evaluating financial statements that present a breadth and level of complexity of issues that can reasonably be expected to be raised by the registrant’s financial statements, or experience actively supervising one of more persons engaged in such activities.61

The Commission requires the following disclosure:

that the board of directors has determined that the fund either (i) has at least one audit committee financial expert serving on its audit committee, or (ii) does not have an audit committee financial expert serving on its audit committee;

if so, disclose the name of the audit committee financial expert and whether that person is “independent”; and

if not, explain why the fund does not have an audit committee financial expert.62

61 Id. at Item 3.(b).

62 Id. at Item 3.(a).

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b. Derivatives Expert

The Commission currently has proposed63 a rule regarding funds’ buying derivatives that has raised the question whether fund boards of directors would need to have members who are experts on derivatives.

The proposed rule, briefly summarized, requires fund directors to:

approve one of two alternative portfolio limitations that would apply to the fund;

approve policies and procedures reasonably designed to provide for a fund’s maintenance of qualifying coverage assets;

approve an alternative portfolio limitation regarding the fund’s aggregate exposure resulting from derivatives transactions; and

consider the approval of any initial program of the fund and any material changes to it, review a written report, at least quarterly, by the person responsible for administering the program that describes the adequacy of the program and the effectiveness of its implementation, and approve the designation of the person selected as the risk officer.

A number of commenters objected to the proposal to the extent that it imposes duties on fund directors that are inconsistent with the traditional oversight role of directors and requires a level of expertise that fund directors generally do not have.

63 Use of Derivatives by Registered Investment Companies and Business Development Companies, Investment Company Act Release No. 31933 (Dec. 11, 2015), available at www.sec.gov/rules/proposed/2015/ic-31933.pdf.

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For example, one commenter with extensive experience in the industry, stated that “[m]y concerns principally relate to the substantial responsibilities entailing decision on highly technical matters that would be assigned to Fund boards under the Proposal.”64

The Independent Directors Conference submitted a comment on the Commission’s proposal that expressed similar concerns as follows:

[W]e are aware that members of the Commission staff have stated that the proposal is not intended to impose management function on fund boards. While we do not question their sincerity, we note that many in the director community and others in the industry view the proposal quite differently. Rather than emphasize the board’s role in overseeing the portfolio management function, the proposal seems to push boards into the realm of the decision making that is part of the portfolio management function and more appropriately within the adviser’s purview. . . . Fund directors are not engaged on a day to day basis in fund management and operations and do not have, nor should they be expected to have, the technical, on the ground expertiseof the adviser and other service providers. To reconcile these differing views, we urge the Commission to modify the proposal . . . to characterize directors’ responsibilities consistent with its statements that it is not

64 Letter of Robert G. Zack, Attorney at Law, to Brent J. Fields, Secretary, SEC 5 (March 29, 2016) (emphasis added), available at www.sec.gov/comments/s7-24-15/s72415-189.pdf.

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intending to impose management functions on fund boards.”65

Chairman White, to her credit, seems to have anticipated comments objecting to the proposed role for fund directors, as follows:

[T]he Commission approved another proposal in December [2015] regarding the use of derivatives by funds. That proposal also includes an oversight role for fund directors --requiring the board of a fund to approve one of two alternative portfolio limitations on the fund’s use of derivatives and to approve policies and procedures for managing risks associated with the fund’s derivatives transactions. Comments on the derivatives proposal were due yesterday, and I look forward to considering the views from commenters on the overall proposal, as well as on the specific point of the board’s proposed role.66

2. Actuary as Outside Expert

If underlying funds need not have actuaries on their boards of directors, a secondary question arises whether such fund boards should hire outside actuarial experts to analyze the variable insurance product contract, study the fee levels, and advise the directors.

65 Letter of Amy B.R. Lancellotta, Managing Director, Independent Directors Council, to Brent J. Fields, Secretary, SEC 3 (March 28, 2016)(emphasis added, footnote omitted), available at www.sec.gov/comments/s7-24-15/s72415-123.pdf.

66 Mary Jo White, Chairman, U.S. Securities and Exchange Commission, The Fund Director in 2016 Keynote Address at the Mutual Fund Directors Forum 2016 Policy Conference (March 29, 2016)(emphasis added), available athttps://www.sec.gov/news/speech/chair-white-mutual-fund-directors-forum-3-29-16.html [hereinafter Chairman White Policy Speech].

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The SEC’s Rule prescribing governance standards for fund directors, requires that:

[t]he disinterested directors have been authorized to hire employees and to retain advisers and expertsnecessary to carry out their duties.67

The mutual fund industry has agreed with the SEC in regard to funds’ hiring needed outside experts, although not in the specific context of underlying fund Rule 12b-1 plans.

For example, the Investment Company Institute has recommended that:

[i]ndependent directors have qualified investment company counsel who is independent from theinvestment adviser and the fund's other service providers; and that independent directors have express authority to consult with the fund's independent auditors or other experts, as appropriate, when faced with issues that they believe require special expertise. 68

The Mutual Fund Directors Forum has proclaimed that:

[a] fund’s independent directors should employ . . . consultants when necessary to assist them in carrying out their duties.69

67 Rule 0-1(a)(7)(vii)(emphasis added).

68 Investment Company Institute, A Summary of the Report of the Advisory Group on Best Practices for Fund Directors (June 1999) (emphasis added), available at https://www.idc.org/idc/issues/governance/governance/publications/99_sec_fund_gov_best_sum.

69 Mutual Fund Directors Forum, Practical Guidance for Mutual Fund Directors 8 (Oct. 2013), available at http://mfdf.org/images/DirResPDFs/MFDF_Practical_Guidance_Oct2013_web.pdf.

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Notwithstanding fund board of directors authority to hire outside experts and consultants, the question remains whether underlying fund directors should be deemed to have a duty to review, analyze and evaluate the cost structure of variable insurance product contracts.

To deem underlying fund directors to have such a duty arguably flies in the face of Chairman White’s view, set out in 3., below, and the Commission’s proposed alternative to Rule 12b-1, discussed in E., below.

3. Chairman White Has Said that Directors Can Rely on Information from Others

Chairman White’s speech to the industry last year can be read to say that, in the context of Rule 12b-1 plans, fund directors have a duty to understand the distribution process forfund shares as a whole and be able to rely on information furnished by relevant service providers.

Chairman White statements did not address 12b-1 plans of underlying funds per se. Therefore, it is not certain that her statements would apply to underlying fund Rule 12b-1 plans. On the other hand, her statements were in the context of 12b-1plans generally and can be read to be broad enough to apply to underlying funds.

Chairman White said:

Another area of current discussion is the appropriate role of the board in ensuring that fund payments to financial intermediaries that are being used to finance distributions are paid pursuant to a rule 12b-1 plan. Recent staff guidance explicitly addresses this issue and acknowledges that mutual fund boards are typically not involved in the day-to-day negotiations of particular distribution arrangements. The staff’s view is that the board should focus on understanding the overall distribution process as a whole to inform its judgment about whether certain

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fees represent payments for distribution and should be able to rely on the adviser and other relevant service providers to provide information about these arrangements.70

And she said that “judgments that directors make in good faith based on responsibly performing their duties will not be second guessed.”71

E. Commission Has Proposed Alternative that Relieves Directors of Making Findings

The Commission has proposed72 an alternative approach to Rule 12b-1 stating that Rule 12b-1 does not fit current circumstances in the industry, as addressed in 1., below.

The Commissioner’s proposal would relieve fund directors of having to approve plans or make any special findings, as addressed in 2., below. The proposal treats underlying funds the same way it treats retail funds, as discussed in 3., below.

It arguably follows that any question regarding underlying fund Rule 12b-1 plans, including any question about the duty of underlying fund directors, should be deferred until the Commission has determined whether or not to adopt its proposal. This Outline discusses the prospects of the Commission’s adopting the proposal in Part V.B., below.

1. Proposal

The Commission’s proposal would rescind Rule 12b-1 and substitute a new approach to the use of fund assets for distribution.

70 Chairman White Policy Speech, supra note 66, at 5 (emphasis added; citation omitted).

71 Id.

72 SEC 12b-1 Alternative Proposal Release, supra note 5.

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The Commission’s new approach posits that current Rule 12b-1 fees have two constituent parts -- a marketing and service fee and a sales load. The Commission proposes to permit a marketing and service fee under a new Rule 12b-2and a sales load under an amended Rule 6c-10.

The Commission describes the marketing and service fee under proposed new Rule 12b-2 as follows:

The new approach we propose would, like NASD Conduct Rule 2830, differentiate between the two constituent parts of current 12b-1 fees (asset-basedsales charges and service fees). Under proposed new rule 12b-2, funds could continue to use a limited amount of fund assets to pay for distribution related expenses. The maximum amount of this “marketing and service fee” would be tied to the service fee limitimposed by the NASD sales charge rule (currently 25 basis points per year). Unlike the service fee, however, funds could use this portion of fund assets for any distribution related expenses. This approach would serve the interests of investors and other members of the fund marketplace by providing a means of paying for participation in fund supermarkets and the maintenance of shareholder accounts, among other things, and allowing funds to support their ownmarketing and distribution strategies.73

The Commission describes the sales load under proposed amended Rule 6c-10 as follows:

We also propose to permit funds to deduct fromfund assets amounts in excess of the marketing and service fee, and we would treat these amounts as an alternative means to pay a front-end sales load. To accomplish this, we propose to amend rule 6c-10 (which permits funds to charge deferred loads) to

73 Id. at 38 (footnotes omitted).

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permit this asset-based sales charge, which we would call an “ongoing sales charge.” The proposed amendments in effect would treat ongoing sales charges as another form of sales load.

Instead, we would apply limits on asset-based sales charges by referencing the front-end load imposed by the fund or, if none, by referencing the aggregate sales load cap imposed under the NASD sales charge rule for funds with an asset-based sales charge and service fee (currently 6.25 percent).

These limits would be based on the cumulative amount of sales charges that an investor pays in any form (front-end, deferred, or asset-based). Under the proposed rule amendment, a fund imposing an ongoing sales charge would be required to automatically convert fund shares to a class of shares without an ongoing sales charge no later than when the investor has paid cumulative charges that approximate the amount the investor otherwise would have paid through a traditional front-end load (or, if none, the NASD rule 6.25 percent cap). The proposed amendment would shift the focus of the limits from how much fund underwriters may collect in asset-based sales charges (a fund-level cap) to how much individual shareholders will pay either directly or indirectly (a shareholder account-level cap).74

The Commission describes an alternative sales load under proposed amended Rule 6c-10 as follows:

We are also proposing to amend rule 6c-10 to permit an alternative, elective distribution model. In this new model, intermediaries of funds could impose charges for sales of the fund’s shares at negotiated rates, much like they charge commissions on sales of

74 Id. at 38-39 (emphasis in original; footnotes omitted).

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exchange-traded funds (ETFs) and other equity securities. The proposed rule would permit fund intermediaries to charge sales loads other than those established by the fund underwriter and disclosed in the fund prospectus.75

2. Role of Fund Directors

The Commission has noted that current realities in the fund industry are at odds with the Rule 12b-1 requirements that fund directors consider certain factors and determine that a Rule 12b-1 plan has a reasonable likelihood to benefit thecompany and its shareholders. The Commission has stated that

many of the assumptions underlying the rule appear to no longer reflect current marketplace realities,including the role that 12b-1 fees play in the distribution of fund shares and the tasks that directors should be required to undertake in considering whether to approve 12b-1 plans.76

Indeed, the Commission’s Rule 12b-1 alternative proposal would relieve fund directors of having to make any finding currently required by Rule 12b-1. The Commission has stated:

Our proposed amendment to rule 6c-10 would not require any special board findings (such as those required by rule 12b-1), a written plan, annual renewal, or automatic termination provisions, or impose fund governance requirements.77

3. Underlying Fund Use of Assets for Distribution

75 Id. at 39 (footnotes omitted).

76 Id. at 40 (emphasis added).


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The Commission has stated that its Rule 12b-1 proposal would apply to underlying funds. However, at the same time, the Commission raised its traditional concern whether underlying fund distribution fees should be limited, given the fact that fees are imposed under variable insurance product contracts at the separate account level.

The Commission has specifically addressed underlying funds, as follows:

Our proposed rule and rule amendments would apply to funds that serve as investment vehicles for insurance company separate accounts that offer variable annuities or life insurance contracts. Separate accounts are typically organized as unit investment trusts. They invest the proceeds of premium payments made by contract owners in one or more mutual funds (underlying funds) that manage the assets that support the insurance contracts.78

The Commission has noted that variable insurance product owners pay distribution fees imposed by product contracts and, in some cases, also by underlying fund Rule 12b-1 plans, as follows:

Owners of variable insurance contracts may pay substantial distribution costs in the form of a front-end load, a contingent deferred load, or ongoing charges that are deducted from the assets held by the separate account, or a combination of these charges. In addition, directors of some underlying funds have approved adoption of rule 12b-1 plans to support various distribution and shareholder servicing activities. We understand that in most cases these charges do not exceed 25 basis points annually.79

78 Id. at 83-84 (footnotes omitted).


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The Commission, at least in the first instance, has explained that its Rule 12b-1 proposal would apply to underlying funds in the same manner as it does to retail funds, as follows:

Under our proposed rule changes, underlying funds would be treated like other mutual funds. Thus, an underlying fund could charge a marketing and service fee up to the NASD sales charge rule limit on service fees. Asset-based distribution fees in excess of the marketing and service fee would be deemed ongoingsales charges and subject to the requirements of the proposed amendments to rule 6c-10. Like other mutual funds, in order to impose an ongoing sales charge under proposed rule 6c-10(b), an underlyingfund (or the insurance company sponsor) would have to keep track of share lots attributable to contract owner purchase payments, and provide for the automatic conversion of shares by the end of the conversion period. We understand that insurance company separate accounts may not currently track and age shares because they generally do not offerunderlying funds with contingent deferred sales loads. Under our proposal, insurance companies would either have to develop this capability or offer only shares of classes that do not impose an ongoing sales charge.80

However, the Commission has gone on to question whether treating underlying funds in the same manner as retail funds would be justified, as follows:

We request comment on whether we should treat underlying funds differently than other funds.

Given that most distribution activities occur at the separate account-level, is it appropriate to permitunderlying funds to impose the marketing and

80 Id. at 85 (emphasis added; footnote omitted).

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service fee or ongoing sales charges? How would these fees be used? Should we limit underlying funds to the marketing and service fee? Should we consider some other structure for limiting fees charged by underlying funds?81

4. Irrelevance of Factors Under Current Circumstances

The Commission and its Staff have recognized that the factors are not necessarily as relevant now as they were when the Commission conceived them. This is because the apparent original purpose of Rule 12b-1 plans has changed.

The Commission may have originally conceived Rule 12b-1 plans as a temporary means of sustaining a fund during a “prolonged period of high redemptions . . . which reduced the amount of fund assets.”82 However, the Commission and its Staff have since recognized that Rule 12b-1 plans have become a means of providing continuing financing for the distribution of fund shares. As the Staff has stated, “since 1980 when the 12b-1 Adopting Release was issued, fund’s distribution structures and the purpose and use of 12b-1 fees has evolved significantly.”83

It follows that the factors that the Commission originally listed are outdated and need to be updated.

Then Commission Chairman William Donaldson so recognized in connection with information that he provided in response to a 2003 Congressional request, as follows:


82 Id. at 11.

83 SEC Division of Investment Management, IM Guidance Update, Mutual Fund Distribution and Sub-Accounting Fees 14 n.23, No. 2016-01 (Jan. 2016)(emphasis in italics in original; emphasis in boldface added), available athttps://www.sec.gov/investment/im-guidance-2016-01.pdf [hereinafter SEC Staff Distribution-in-Guise Guidance].

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[T[he adopting release for rule 12b-1 included a list of factors that fund boards might take into account when they consider whether to approve or continue a 12b-1 plan. Many of the factors presupposed that funds would typically adopt 12b-1 plans for relatively short periods in order to solve a particular distribution problem or to respond to specific circumstances, such as net redemptions. Although the factors are suggested and not required, some industry participants indicate that the factors are given great weight by fund boards. Some argue that the recitation of the factors impedes board oversight of 12b-1 plans because the temptation to rely on the factors, whether they are relevant to a particular situation or not, is too great to ignore. Although the factors may have appropriately reflected industry conditions as they existed in the late 1970s, others argue that many have subsequently become obsolete because, today, many funds adopt a 12b-1 plan as a substitute for or supplement to sales charges or as an ongoing method of paying for marketing and distribution arrangements.84

The Investment Company Institute has recommended that the Commission modernize the factors, as noted in the following statement:

The SEC is currently considering potential changes to Rule 12b-1. In the past, ICI has supported retaining the basic framework of Rule 12b-1. To help ensure that investors understand these fees, however, ICI has proposed improving disclosure about 12b-1fees and how they are used. In addition, ICI has recommended modernizing the guidance provided

84 Letter from William H. Donaldson, SEC Chairman, to Richard H. Baker, Chairman, House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises (June 9, 2003).

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to boards regarding the factors they may consider in approving and continuing 12b-1 plans.85

The Staff, earlier this year, recognized that some of the factors that the Commission had listed in 1980 are not necessarily pertinent any longer, as follows:

[C]ertain of the factors noted in the 12b-1Adopting Release may no longer be pertinent to a fund board’s current evaluation of whether a 12b-1plan should be implemented or continued, while other factors not included in that release may be. Accordingly, in the staff’s view, it would not be necessary for boards to make a finding about eachof the factors laid out in the 12b-1 adopting release [sic] if such factors are not pertinent to boards’ evaluation of whether a 12b-1 plan should be implemented or continued in the current environment.86

IV. QUESTION OF IMPOSING RULE 12b-1 PLAN FEES AFTER SURRENDER CHARGE PERIOD HAS RUN OR AFTER CEASING TO OFFER PRODUCT

A. Question Raised

When a life insurance company sells a contract, it pays a commission to the salesperson. This means that the life company is advancing money to pay the salesperson and must recoup that outlay.

If a contract owner withdraws money or surrenders the contract during the first seven years or so, the life company imposes a surrender fee – on top of all the other fees – to cover that initial salesperson commission.

85 Investment Company Institute, 12b-1 Resource Center, Introduction (undated, emphasis added), available at https://www.ici.org/rule12b1fees.

86 SEC Staff Distribution-in-Guise Guidance, supra note 83, at 14.

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If the contract holder withdraws or surrenders after the first seven years or so, the life company has recouped the commission through asset-based fees under the contract and any surrender fee.

If the contract holder keeps the contract beyond the surrender fee period, the insurance company will recoup its initial outlay for the commission, but contract owners will continue to pay Rule 12b-1 plan fees at the underlying fund level.

Furthermore, a life insurance company may discontinue offering a particular product.

Should underlying fund directors request and evaluate information about the contract fees and surrender fees, as well as the persistency rates showing how many contracts are held beyond the surrender period?

The answer to each question is arguably no, based on the facts and circumstances set out below.

B. Commission Has Said Rule 12b-1 Fees Cover Continuing Distribution Expenses

Distribution expenses do not end following the completion of a surrender charge period under a variable insurance product or a life insurance company’s cessation of offering such a product. Accordingly, Rule 12b-1 plans are arguably justified in continuing to impose fees following such events.

Variable insurance products typically provide for further purchases of underlying fund shares and reallocations of assetsamong underlying fund investment options.. These provisions typically extend for the life of the product contracts, which can extend for long after surrender periods have run or life insurance companies have ceased offering the products.

The Commission has conceptualized Rule 12b-1 plan fees as covering distribution expenses associated with the initial sale, as well as service expenses continuing after the initial sale. As the Commission has stated, there are “two constituent parts of current

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12b-1 fees (asset-based sales charges and service fees).”87 The Commission has further recognized that services are usually provided on a continuous basis after the initial sale, as follows:

A significant use of 12b-1 fees today is for what is typically characterized as “services” to investors after the sale by the broker-dealers and other intermediaries who sell the fund. According to the Investment Company Institute, more than half of all 12b-1 fees are used for this purpose.88

The Commission has recognized that such services can include, for example, “responding to customer inquiries, providing information on investments, and reviewing customer holdings on a regular basis.”89

It arguably follows that Rule 12b-1 fees are justified to cover services that continue to be provided following the end of a surrender period or the cessation of offering a variable insurance product.

87 SEC 12b-1 Alternative Proposal Release, supra note 5, at 38.

88 Id. at 26 (emphasis added; footnote omitted).

89 Id.

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V. QUESTION OF DEGREE OF DETAIL TO BE REPORTED TO DIRECTORS

A. Question Raised

Rule 12b-1 plan fees may flow from the fund to the life insurance company distributor to retail broker-dealers to individual salespersons.

Should underlying fund directors consider the specific services provided in return for Rule 12b-1 plan fees? Is it sufficient for directors to be provided with information that Rule 12b-1 fees were paid for trail commissions, without further detail as to the precise services provided in return for the trail commissions?

B. Commission Has Identified Services

Retail broker-dealers provide continuing “hand-holding” services for their clients. As noted above, the SEC has identified these services as “responding to customer inquiries, providing information on investments, and reviewing customer holdings on a regular basis.”90

So, there’s arguably only a limited and common universe of services typically performed in return for trail commissions, and these could be easily specified.

C. Commission Has Not Required Certain Information To Be Provided to Fund Boards

Notwithstanding the foregoing, retail broker-dealers, for whatever reason, may not want to share detailed information in connection with the specific services that they provide to clients. This situation with broker-dealers is arguably analogous to the situation where sub-investment advisers typically do not share profit information with the board of directors of client funds in the Section 15(c) process for continuing investment advisory agreements.

90 Id.

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Arguably, if the Commission believes that mutual fund boards should have such information, the Commission should require the holders of the information to provide it.

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VI. COMMISSION CONTEXTS FOR ADDRESSING UNDERLYING FUND RULE 12b-1 PLANS

The Commission could address underlying fund Rule 12b-1plans, including the duty of underlying fund directors, in a number of contexts. These contexts include the current Staff distribution-in-guise initiative, the Commission’s proposed alternative approach to Rule 12b-1, the life insurance industry’s VA summary prospectus and layered disclosure initiative, and the SEC Investor Advisory Committee recommendations regarding fund prospectus disclosure.

A. Distribution in Guise

The Staff’s current, or at least recent, distribution-in-guise initiative addresses “issues that may arise when registered open-end investment companies . . . make payments to financial intermediaries that provide shareholder and recordkeeping services for investors whose shares are held in omnibus and networked accounts maintained with mutual funds.”91 The chief issue that arises is “whether a portion of those payments are being used to finance distribution and therefore, if paid by a fund, must be paid pursuant to rule 12b-1 under the Investment Company Act.”92

In a nutshell, the Staff last year conducted a “sweep examination of a number of mutual fund complexes, investment advisers, broker-dealers, and transfer agents.”93 The Commission brought and settled an enforcement action,94 and the Staff published guidance.95

91 Id. at 43.

92 Id.

93 Id. at 1.

94 In Re First Eagle Investment Management, Investment Advisers Act Release No. 4199, Investment Company Act Release No. 31832 (Sept. 21, 2015), available at https://www.sec.gov/litigation/admin/2015/ia-4199.pdf.

95 SEC Staff Distribution-in-Guise Guidance, supra note 83.

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The Staff guidance did not involve the issue of underlying fund Rule 12b-1 plans.

B. Proposed Alternative Approach to Rule 12b-1

The Commission, as noted above, has proposed96 an alternative approach to Rule 12b-1. The Commission has stated that the new approach would apply to underlying funds in the same way it would for retail funds.

The Commission has not followed up on its Rule 12b-1proposal, presumably because it has had to give priority to adopting rules mandated by the JOBS Act and Dodd-Frank Act.

The Commission may be approaching the end of adopting the mandated rules in the next year or so. If so, the Commission could return to its Rule 12b-l proposal. Set out below are circumstances that suggest that the Rule 12b-1 proposal is dead (1., below) and circumstances that suggest that the proposal is still alive (2., below).

1. Circumstances Suggesting that Rule 12b-1 Alternative Proposal Is Dead

There are a number of circumstances suggesting that the Commission will not take up its Rule 12b-1 proposal.

All of the Commissioners in office at the time voted97 in favor of the Rule 12b-1 Proposal. However, all of these Commissioners Mary L. Schapiro, Kathleen L. Casey, Elisse B. Walter, Luis A. Aguilar, and Troy A. Paredes -- have left the SEC. So, the current SEC Chairman and Commissioners had nothing to do with the Rule 12b-1 proposal.

96 SEC 12b-1 Alternative Proposal Release, supra note 5.

97 SEC, Final Commissioner Votes (April 2006 - December 2015), July 2010 at 2, 482-759, available at https://www.sec.gov/foia/foia-votes.shtml.

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The SEC submitted98 its rulemaking list to the Office of Management and Budget last October. The list does not include the Rule 12b-1 proposal.

2. Circumstances Suggesting that Rule 12b-1 Alternative Proposal Is Still Alive

a. Proposal Not Withdrawn

Despite the fact discussed above that the SEC does not list the proposal on its Agency Rule List for Fall 2016, the SEC has not officially withdrawn its proposal.

Accordingly, the Rule 12b-1 proposal, at least officially, appears to continue to be an SEC proposal.

b. Proposal Author Back on Staff

The approach that the Commission laid out in its Rule 12b-1 proposal is thought to have been developed by Andrew J. “Buddy” Donohue who was Director of the Division of Investment Management at the time.

Mr. Donohue resigned and left the staff in November 2010, just a few months after the SEC published its Rule 12b-1 proposal the previous July. The SEC has not publicly taken up the Rule 12b-1 proposal since Mr. Donohue left the staff.

However, Mr. Donohue rejoined the Staff in 2015 as Chairman White’s Chief of Staff.99 The Commission

98 SEC Agency Rule List - Fall 2016, U.S., U.S. General Services Administration, Office of Information and Regulatory Affairs, Office of Management and Budget, available at http://www.reginfo.gov/public/do/eAgendaMain?operation=OPERATION_GET_AGENCY_RULE_LIST&currentPub=true&agencyCd=3235&Image58.x=58&Image58.y=9.

99 Press Release 2015-103, SEC, SEC Names Andrew J. Donohue as Chief of Staff (May 28, 2015), available at https://www.sec.gov/news/pressrelease/2015-103.html [hereinafter SEC Donohue Press Release]. Mr. Donohue, as stated in

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describes Mr. Donohue as “a senior adviser to the Chairman on all policy, management, and regulatory issues.” 100 So, Mr. Donohue has been in a position to help revive the Rule 12b-1 proposal at the Commission level, once the Commission completes its rulemaking agenda that the JOBS Act and Dodd-Frank Act mandates.

Following Mr. Donald Trump’s election as President, Chairman White announced that she would leave the SEC “at the end of the Obama administration.”101 The SEC, as of January 11, 2017, has not made any announcement regarding Mr. Donohue.

The Rule 12b-1 proposal has been commonly thought to have credibility because of Mr. Donohue’s experience and expertise from serving in prominent positons in the mutual fund industry.102 Most recently, Mr. Donohue was managing director, associate general counsel, and investment company general counsel at Goldman, Sachs & Co. in New York, where he was primarily responsible for legal matters related to its registered investment companies. Prior to that, he was a partner in the Investment Management Practice Group at Morgan Lewis & Bockius LLP in New York from March 2011 to October 2012. From May 2003 to May 2006, Mr. Donohue served as global general counsel at Merrill Lynch Investment Managers in New Jersey, where he oversaw the firm’s legal, regulatory and compliance matters for the investment advisory business. From June 1991 to November 2001, Mr. Donohue served as executive vice

the Press Release, served as Director of the Division of Investment Management from May 2006 to November 2010.

100 Id.

101 Press Release 2016-238, SEC, SEC Chair Mary Jo White announces Departure Plans (Nov. 14, 2016), available at: https://www.sec.gov/news/pressrelease/2106-238.html.

102 The following language in the text is paraphrased from id.

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president, general counsel, director, and as a member of the executive committee of the investment fund subsidiary of Massachusetts Mutual Life Insurance Company, Oppenheimer Funds Inc.

Chairman White, at the time, said:

I am thrilled that Buddy will be returning to the SEC to provide his extensive knowledge and expertise to the agency. Buddy is a seasoned professional whose previous SEC and private sector experience will be invaluable in advancing all aspects of the agency’s mission. His deep knowledge of asset management will be especially useful as the Commission advances its rulemaking agenda for addressing potential risks in asset management and considers a uniform fiduciary standard.103

c. Former SEC Chair Appointed to SEC Investor Advisory Committee

As noted above, all five Commissioners who voted in favor of the Rule 12b-1 Alternative Proposal have left the SEC.

However, as also noted above, former SEC Chairman Elise Walter, who was a Commissioner at the time the Proposal was made, has become a member of the SEC Investor Advisory Committee.

d. Proposal Could Have Appeal for Republicans

A Trump administration could support the Proposal in that it relieves directors of burdensome responsibilities. At the time the Commission approved the Proposal, both Republican Commissioners voted in favor of the Proposal.

103 SEC Donohue Press Release, supra note 99 (emphasis added).

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C. Summary VA Prospectus and Layered Disclosure Initiative

The Commission could address underlying fund Rule 12b-1plans in the context of life insurance industry efforts to have the Commission adopt a summary prospectus and layered disclosure for VAs.104

As noted II.B., above, the Commission has required disclosure regarding underlying fund Rule 12b-1 plans in separate account prospectuses.

The Commission proposed105 a summary prospectus and layered disclosure for mutual funds on November 21, 2007, nine years ago, and adopted106 its proposal on January 13, 2009, more than seven and a half years ago.

The Staff announced, in March, 2013, that the VA summary prospectus and layered disclosure was a “regulatory priority” of the Commission,107 but the Commission has repeatedly pushed off

104 For a detailed history of this matter, see Gary O. Cohen, Mad Men to Whistleblowers: Disclosure Developments Impacting Variable Insurance Products and Underlying Mutual Funds, in ALI-CLE Conference on Life Insurance Company Products, Current SEC, FINRA, Insurance, Tax and ERISA Regulatory and Compliance Issues, ALI CLE Study Materials 637, 655 (2013).

105 Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies, Securities Act Release No. 8861, Investment Company Act Release No. 28064 (Nov. 21, 2007).

106 Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies, Securities Act Release No. 8998, Investment Company Act Release No. 28584 (Jan. 11, 2009).

107 Norm Champ, Director, SEC Division of Investment Management, Remarks to the Investment Management Institute 2013 at 4 (March 7, 2013)(David W. Grim, Deputy Director, Division of Investment Management delivered the remarks in Mr. Champ’s absence)(transcript available at www.sec.gov/News/Speech/Detail/Speech/1365171515032).

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the date of consideration, presumably pending completion of rule-making mandated by the JOBS Act and the Dodd-Frank Act.

The Commission’s currently announced108 date for considering the matter is October 2017.

D. Investor Advisory Committee Recommendation

The Commission could address underlying fund Rule 12b-1plans in the context of the SEC Investor Advisory Committee.

Last year, the Investor Advisory Committee submitted a recommendation109 to the Commission regarding fund cost disclosure. The recommendation per se does not relate to the issue addressed in this Outline, because it relates to only the disclosure of fund costs generally and does not relate to underlying fund costs specifically.

However, the recommendation does relate to the cost to investors of Rule 12b-1 plans. The Committee, for example, criticized the concept of the prospectus fee table, as follows:

It is unclear what benefit the typical investor gets from the break-down of annual fund operating expenses, for example, and the provision of that detailed information in the fee table adds greatly to the complexity of the disclosures. Similarly, some of the labels are likely to be

108 Notice of semiannual regulatory agenda [sic], Securities Act Release No. 10203, Securities Exchange Act Release No. 78769, Investment Advisers Act Release No. 4521, Investment Company Act Release No. 32251 (Sept. 2, 2016), available at http://www.sec.gov/rules/other/2016/33-10203.pdf; Office of Management and Budget, Office of Information and Regulatory Affairs, Agency List – Fall 2016, available athttp://www.reginfo.gov/public/do/eAgendaMain?operation=OPERATION_GET_AGENCY_RULE_LIST&currentPub=true&agencyCd=3235&Image58.x=58&Image58.y=9.

109 SEC Investor Advisory Committee, Recommendations of the Investor as Purchaser Subcommittee Regarding Mutual Fund Cost Disclosure (Apr. 14, 2016), available at https://www.sec.gov/spotlight/investor-advisory-committee-2012/recommendation-mf-fee-disclosure-041916.pdf.

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confusing to financially unsophisticated investors. Labeling sales charges “Shareholder Fees,” for example, seems to unnecessarily obscure the purpose of these fees. And describing 12b-1 fees as “distribution or service fees” does little to clarity their significance. 110

Conceivably, the recommendation regarding disclosure of Rule 12b-1 plan fees could have the effect of causing the Commission to think about Rule 12b-1 plans in general and underlying Rule 12b-1 plans specifically. The Investor Advisory Committee told the Commission:

At the very least, we believe the time has come for a comprehensive review of the effectiveness of the required disclosures and alternatives, such as dollar amount cost disclosure on customer account statements, to determine whether changes to these requirements could promote greater cost consciousness among mutual fund investors, more informed investment decision-making, and increased market competition based on fund costs.111

The Commission appointed the Committee pursuant to a mandate in the Dodd-Frank Act. The purpose of the Committee is to advise the Commission112 on regulatory priorities, regulation of securities products, trading strategies, fee structures, disclosure effectiveness, and initiatives to protect investors and promote investor confidence and the integrity of the U.S. securities markets.

110 Id. at “Supporting Rationale” (emphasis added).

111 Id. at “Proposals to Address these [sic] Short-comings” (emphasis added).

112 The Committee appears to enjoy a productive relationship with the SEC. Chairman White has said:

The Commission and investors have significantly benefited from the service of the members of the Committee. They work hard and have compiled an impressive body of work on a wide range of important issues. Their vigorous commitment to investor interests, investor confidence, and the integrity of the securities marketplace is very important and much appreciated.

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The Committee members do not appear to have specific expertise in variable insurance products, underlying funds, or underlying fund Rule 12b-1 plans. One member is Craig Goettsch from the Iowa Insurance Division, but he is Director of Investor Education and Consumer Outreach and may not be involved with substantive regulation.

However, Elise B. Walter, former Chairman of the SEC,113 has recently joined the Committee. Ms. Walter is familiar with variable insurance products through her work on the Commission and as an official of FINRA.114

113 Elisse B. Walter was appointed Commissioner by President George W. Bush and was sworn in on July 9, 2008. She was later designated the 30th Chairman of the SEC by President Barack Obama on November 26, 2012, serving from December 14, 2012 to April 10, 2013. She served as Acting Chairman in January 2009. See https://www.sec.gov/about/commissioner/walter.htm

114 Prior to her appointment as an SEC Commissioner, Ms. Walter served as Senior Executive Vice President, Regulatory Policy & Programs, for FINRA. She held the same position at NASD before its 2007 consolidation with NYSE Member Regulation. See id.

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VII. CONCLUSION

This is the 20th anniversary of underlying fund Rule 12b-1Plans. The Commission adopted Rule 12b-1 in 1980, but effectively banned underlying fund Rule 12b-1 plans until 1996. Since 1996, there has been significant growth of variable insurance product assets and corresponding underlying fund assets. A large number and variety of underlying funds have developed, providing contract owners with a broad choice of investment objectives and policies.

Historically, the Commission and its Staff have been concerned about whether any fund distribution expenses are covered by variable insurance product contract fees. If so, Rule 12b-1 plan fees would not be paid for legitimate services and would constitute double-charging of contract owners. This concern bears on the duty of underlying fund directors in approving or continuing Rule 12b-1 plans in compliance with Rule 12b-1’s requirements.

Congress amended the 1940 Act to require life insurance companies selling variable insurance products to represent that fees deducted under the contracts are reasonable. This approach, which the Staff originally recommended, arguably relieves underlying fund directors from having to request and evaluate information about fees imposed under variable insurance product contracts.

To the extent that the Commission and its Staff continue to have concern about underlying fund Rule 12b-1 plans, there are a number of contexts in which the Commission could address that concern. These contexts include the Staff’s distribution-in-guise initiative, the Commission’s proposed alternative to Rule 12b-1, the life insurance industry’s initiative to have the Commission adopt a summary prospectus and layered disclosure for VAs, and the SEC Investor Advisory Committee’s recommendation to the Commission regarding fund cost disclosure.

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