Rule 12b-1 of the Investment Company Act of 1940 authorizes mutual funds to pay for marketing and distribution expenses directly from the investment assets of shareholders, effectively treating those sales expenses as akin to other operating expenses of the mutual fund.
Because the 12b-1 fee is paid directly by fund investors, the fund’s board of directors must approve a 12b-1 plan before such fees can be assessed (and the board also has a responsibility to monitor the use of the 12b-1 fee over time).
Technically, the 12b-1 fee is comprised of two pieces – a distribution and marketing fee that can be up to 0.75%/year, and a service fee of up to 0.25%/year (for a combined maximum total of 1.0%/year). Accordingly, “A share” mutual funds, which pay a separate upfront sales commission for distribution and marketing, typically have only a 0.25%/year 12b-1 service fee, while “C share” mutual funds that don’t otherwise pay an upfront commission rely on the 0.75% distribution fee + 0.25% service fee = 1% total 12b-1 fee to compensate their salespeople.
Notably, from its start, the 12b-1 fee was controversial. At its core, it imposes an obligation on current investors to pay for the cost for the fund company to market to other people who are not yet investors; in other words, current fund investors pay for the fund company’s salespeople and marketing efforts to get new investors, rather than having the fund company itself pay to grow its business. This is an important contrast to traditional upfront commissions, because those payments do come directly from the fund company (and/or the investor’s own dollars directly), not the aggregate of other mutual fund investors. (Notably, “B share” mutual funds allowed broker-dealers to pay brokers an upfront commission, and then recover it over time through the 12b-1 fee, though use of B shares has been in decline.)
In fact, the Investment Company Act of 1940 itself originally banned the use of investor assets to pay for a mutual fund’s marketing and distribution. However, when Rule 12b-1 was first adopted in 1980 under Investment Company Act Release No. 11414, the justification for taking the mutual fund’s marketing expenses directly from shareholders themselves – even though those marketing expenses to grow the fund would enrich the fund company – was that given the underlying fixed costs to run a mutual fund in the first place, adding more investors would allow the fixed costs to be amortized over more investors, bringing the average cost down for everyone, and thus actually benefiting the investors in the long run.
The opportunity to assess a 12b-1 fee to help grow the fund was viewed as an especially important opportunity for smaller/newer mutual funds, that might not have the capital to invest in marketing and distribution themselves, but could use 12b-1 fees assessed on investor assets to grow the fund and ultimately benefit both the fund company (by making the fund larger) and the investors themselves (by scaling the operating costs of the fund and bringing down the expense ratio over time).