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12b-1 plans helping to attract assets

Special charges which fund companies themselves pay intermediaries rather than passing them on to investors are becoming an accepted, although unwelcome, cost of doing business. The payments from mutual fund companies' own profits -- sometimes under so-called "defensive" 12b-1 plans -- are supplementing commissions and traditional Rule 12b-1 fees which investors pay. The need to make extra payments has grown as distribution through intermediaries has increased in importance and traditional sales charges have decreased on average, according to fund industry executives, lawyers and consultants.

Fidelity Investments now is in the midst of obtaining approval from shareholders for making such special payments. On Nov. 16, Fidelity filed a proxy statement with the Securities and Exchange Commission for three of its funds -- Growth Company, Emerging Growth and New Millennium -- in which it asked shareholders to approve a defensive 12b-1 plan.

The plan, whose costs will not be passed to investors, permits Fidelity to pay intermediaries from "past profits and other resources, including management fees paid by a fund," according to the proxy statement. The cost of traditional 12b-1 plans are paid by fund shareholders. Fidelity said it was taking the action to respond to "potentially subjective and ambiguous language" in securities law rules and SEC pronouncements on the application of the Investment Company Act's Rule 12b-1. Rule 12b-1 generally prohibits "indirect" use of fund assets to pay for distribution unless a Rule 12b-1 plan is in place. Eric D. Roiter, Fidelity's general counsel, and one of Fidelity's outside law firms, Kirkpatrick & Lockhart, said in a recent report that defensive 12b-1 plans may help "insulate" a fund adviser from being sued over its fees.

Roiter, who made his comments at a conference this month on mutual fund compliance sponsored by Glasser LegalWorks of Little Falls, N.J., said that the role of intermediaries is becoming ever-more important for fund distribution.

Individual investors increasingly are looking either for advice or reassurance as the size of their investments grow and the number of investment options increase. In addition, the "unit cost" or cost-per-shareholder of reaching new investors through the direct channel has become prohibitive, fund officials say. That combination of factors has given intermediaries leverage.

Indeed, Merrill Lynch has asked funds to make what amounts to an "enhanced 12b-1" from their own profits, industry officials and consultants say. The added fee charged to fund companies is passed on to Merrill representatives whose clients remain in a fund for four years.

"It's an incentive for the reps to keep the assets on the books," said Andrew Guillette, an analyst at Cerulli Associates, the fund research firm. It also can discourage excessive trading, Guillette said.

In proposing its own defensive 12b-1 plan, Fidelity's directors said the company's added payments could both increase fund sales and reduce fund redemptions. That is the primary role which traditional 12b-1 plans have assumed, according to industry executives.

Rule 12b-1 plans, which the SEC first permitted in 1980, initially were intended to pay for a range of distribution costs such as printing, mailing and advertising. However, the charges have largely become a sales commission, industry officials say.

Rule 12b-1 charges "quickly became a proxy for an ongoing commission," Guillette said. Earlier this month, the Investment Company Institute (ICI) said in a report that 12b-1 fees have "absorbed a larger portion of the distribution cost" for funds. At the same time that 12b-1 charges have risen, sales charges have decreased by an even greater amount, the ICI reported. For equity load funds, 12b-1 charges rose from zero to 37 percent of the distribution cost of funds from 1980 to 1997.