In the sketch above, the red circled terminals are the common terminals for the switch. When in the down position these terminals are connected to the terminals with nothing connected to them (above the common terminals in the previous sketch). Therefore the pickup signal is forced thru the resistor and capacitor on its way to the volume pot thereby creating a "padded" signal. With the switch in the up position, the switch essentially creates a short across both the resistor and capacitor thereby sending the full strength signal to the volume pot.
