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Brokers get kickbacks for fund promotion { January 13 2004 } Original Source Link: (May no longer be active)
http://www.washingtonpost.com/wp-dyn/articles/A16531-2004Jan14.htmlhttp://www.washingtonpost.com/wp-dyn/articles/A16531-2004Jan14.html
SEC Proposes to Require Disclosure of Deals
Brokers Rewarded for Promoting Mutual Funds, SEC Finds
By Brooke A. Masters
Washington Post Staff Writer
Tuesday, January 13, 2004; 1:30 PM
A Securities and Exchange Commission review of brokerage firms has found that many brokers are collecting secret payments when they recommend specific mutual funds to their clients, and the SEC today proposed new rules to ensure that consumers are told about such practices and to make mutual fund boards more independent.
SEC officials said yesterday that the practice was widespread -- 13 of 15 firms they examined admitted to taking cash or being rewarded with extra business in exchange for giving favored treatment to the funds of companies who paid them off. And only about half of the companies told their customers about the payments, the SEC said. The SEC declined to name the companies.
The disclosure suggests that many investors may have been steered to particular funds based on advice designed to make money for brokers and mutual fund companies, rather than to best meet the investors' needs, said industry experts. Brokers sold 55 percent of mutual fund shares as of the end of 2002, according to the Investment Company Institute.
The SEC staff has opened enforcement investigations into eight brokerage firms and about a dozen mutual fund companies for possible securities law violations, SEC enforcement division director Stephen M. Cutler said. One of the 15 firms, Morgan Stanley, agreed in November to pay $50 million to settle an investigation into its mutual fund sales practices.
In addition, NASD, which also regulates brokers, has been looking at more than 50 firms to see whether they accept side payments known as "directed brokerage," in which a mutual fund sends its stocks and bond trading orders to the Wall Street firm that recommends its funds. At least some are likely to be disciplined, said Barry R. Goldsmith, the NASD enforcement chief.
"It is a violation of NASD rules to give preference to a mutual fund family in return for directed brokerage, whether it is disclosed or not," he said.
This investigation has the potential to touch far more of the nation's 91 million individual investors than almost any other part of the scandal wracking the $7.2 trillion fund industry, industry observers said. SEC officials said they believe the payments are pervasive, involving a wide variety of firms by size and type.
"Everybody does this, even the reputable firms," said University of Mississippi law professor Mercer E. Bullard, who runs a shareholder advocacy group. "I'm glad the SEC is doing this but frustrated that it took them so long."
The full SEC took up the subject in its meeting today. The five members proposed new rules that would require brokers to tell customers directly about such deals before the customers place an order and to tell individual investors on their confirmation statements exactly how much -- in dollars and cents -- they paid in various kinds of commissions. They also considered rules that would strengthen mutual fund boards and require them to explain annually to shareholders why they believe the funds' fees are reasonable.
"What a sad thing that the SEC has to articulate a rule about what brokers have to say to their customers, when that should have been implicit all along," said Duke University law professor James D. Cox, who studies the industry.
The SEC became interested in the issue of fund companies paying brokers to push their products when their mutual fund inspectors noticed a pattern of mutual fund companies paying surprisingly high commissions to brokers who bought and sold securities for their funds. They also saw that some companies were sending all their trading business to the brokers who also sold their funds to ordinary investors.
But when SEC examiners asked fund companies whether they were paying higher than normal commissions on their stock and bond trades as a way of rewarding brokers that recommended their products, the companies denied it.
So the SEC looked at 15 brokers and found that 10 were getting paid to push mutual funds through the stock and bond commissions, Lori A. Richards, director of the SEC division that did the examinations, said in an interview.
"We believe that it's likely it's an industry-wide practice," Richards said.
Cutler said the SEC is looking at whether the fund companies told the funds' boards of directors about the arrangements and whether the deals violated either disclosure laws or the funds' legal duty to get the "best execution" for stock and bond trades. And he warned that the apparently widespread nature of the practices would not be accepted as an excuse.
"I firmly believe . . . the customer has a right to know what the incentives are when a broker recommends a particular fund," Cutler said at an SEC press conference. "What others do is not going to be a defense."
In addition to proposing that brokers be required to tell customers at the point of sale if they or their firms are getting paid to push that particular fund, the SEC wants customers to receive statements after the sale detailing how much they paid in sales commissions -- called a load -- and how much they can expect to pay over the next year for marketing costs knows as 12b-1 fees, said Annette Nazareth, director of the SEC's division of market regulation, which oversees brokers. The statements would also say how much the broker received in directed brokerage and other side payments.
The commission staff also wants the same statement to say how much -- on average -- brokers across the industry get paid for selling that fund, so customers can compare.
"It's one of the first times we have required comparative data on confirmation statements," Nazareth said.
Sen. Peter Fitzgerald (R-Ill.), who held hearings on the mutual fund industry last year, said he believes the disclosure proposals do not go far enough. "I think it would be better to ban these under-the-table arrangements altogether. . . . This is skimming in the shadows," he said.
Both the ICI, which represents mutual funds, and the Securities Industry Association said they generally support disclosure of incentive payments to brokers.
The SEC also is proposing new rules for fund boards designed to stiffen their spines when negotiating with the fund management company over fees and other charges. The proposed rules, which passed the commission on a unanimous vote today, require that 75 percent of fund directors and the board chairman be independent.
"I think the SEC is moving in the right direction," said Rep. Richard H. Baker (R-La.) who butted heads with the industry last year when he sponsored a bill that would have required fund boards to have an independent chairman. He said he also supports telling investors as much as possible about the fees they pay. "Real dollar disclosure is an excellent step."
© 2004 The Washington Post Company
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