S.E.C. Has Found Payoffs in Sales of Mutual Funds

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S.E.C. Has Found Payoffs in Sales of Mutual Funds

By Stephen Labaton, The New York Times

January 14, 2004

Federal officials announced a new front in the investigations into the mutual fund industry on Tuesday, saying they had uncovered widespread instances of brokers receiving undisclosed payments for steering investors toward specific funds.

Officials at the Securities and Exchange Commission described a kind of mutual fund payola — arrangements where a significant number of mutual funds provided cash and other compensation to the brokerage houses that sell fund shares.

The findings come from a nine-month examination of 15 of the largest Wall Street brokerage firms by the S.E.C.

In one particularly prevalent form of compensation, S.E.C. officials said, the funds steered the trading of the stocks in their portfolios to brokerage houses that would promote the funds to their brokerage clients, in exchange for the trading business.

Such arrangements between fund companies and brokerage houses can be legal, if they are fully disclosed to investors. The problem in too many cases, S.E.C. officials said, is that fund investors were kept in the dark about such payments and about their brokers having a financial interest in promoting a particular fund.

The officials said that federal securities laws and the industry's own rules required both the brokers and the funds to disclose such conflicts of interest.

The S.E.C. officials compared the issue to the conflicts that became prevalent during the stock market boom, when securities analysts were writing ostensibly objective reports about the companies that were giving investment banking business to the analysts' firms.

"A customer has a right to know what the incentives are when the selling broker recommends a particular fund family," said Stephen M. Cutler, the head of the S.E.C.'s enforcement division. He said the agency had recently begun investigating 8 broker-dealers and 12 mutual fund families on suspicion that they had not adequately disclosed such arrangements.
"Even if it is the best-performing fund," Mr. Cutler added, "a customer has a right to know whether a broker received anything for recommending that fund transaction."

Details of the S.E.C. examinations remained somewhat sketchy, as the commission declined to identify which brokers and funds might have been involved. But Tuesday's announcement elevated the mutual fund scandal to a new level, one that has the potential to affect millions of investors directly.

Inadequate disclosure of payments by the fund companies to the brokerage houses has long been suspected, but for years the matter was largely ignored by securities regulators.

Last April, though, S.E.C. inspectors began to focus more intensely on such practices during examinations of mutual funds and Wall Street brokerage firms. The inquiries were a response to evidence that some funds were using brokerage firms to execute stock trades in their portfolios even though there were less expensive trading alternatives, officials said.

The inquiries gained urgency after regulators began in September to look harder at trading practices and corporate governance at the mutual fund companies, having previously focused on the brokerage houses.

Most of the mutual fund cases of the last four months have involved accusations either that a particular large investor received preferential treatment, or that mutual fund executives made trades for their own benefit in ways not available to regular shareholders. In such cases, any financial harm to individual shareholders might be abstract and indirect — perhaps resulting in individuals' not getting quite as good a return on their investment as they might have otherwise received.

But the new disclosures suggested that many ordinary investors were misled, with their investment decisions influenced by brokers who did not adequately disclose relationships that may have colored their recommendations.

S.E.C. officials said they hoped and expected that a new round of enforcement cases against fund companies, combined with a new set of rules, would force the fund companies to be more forthcoming and eliminate conflicts of interest, resulting in lower fees and expenses for investors.

The S.E.C. had already been planning on Wednesday to issue a new set of proposed rules aimed at cleaning up the mutual funds industry. The proposed rules, some of which have been fiercely opposed by the industry's main lobbying organization, will require the boards of fund companies to have chairmen from outside the companies and to allow no more than one-quarter of their directors to be insiders.

The rules would also require the funds to provide clearer disclosures on their fees and expenses and on any conflicts of interest before an investor purchased shares in a fund, and to provide a comparison of the fees and expenses with those charged by other funds.

The S.E.C. has come under political pressure to take steps to clean up the industry and restore investor confidence. The pressure is both from Congress and from state officials, notably the New York State attorney general, Eliot Spitzer. Mr. Spitzer began to pursue enforcement cases against the mutual funds last year, saying the problems had been missed by the S.E.C.

More recently, he has been attacked by top officials of the commission for trying to induce fund companies to lower their fees as part of terms to settle those cases.

William H. Donaldson, the S.E.C. chairman, and other officials have repeatedly said that it is not the government's business to set fees. But they have also said they hoped that by requiring greater disclosure of fees and conflicts, the fund industry would be forced through competitive market pressures to bring their costs down.

Two months ago, the commission indicated it was examining the issue of compensation that mutual funds pay to brokerage houses when Morgan Stanley agreed to pay $50 million to settle a suit brought by the S.E.C. and NASD, formerly the National Association of Securities Dealers. The complaint said the firm had set up preferential arrangements with 16 mutual fund companies.

Shortly before the Morgan Stanley settlement, the nation's oldest mutual fund company, MFS Investment Management, suspended its longtime practice of directing brokerage commissions to securities firms that sold its funds.

S.E.C. officials said on Tuesday that the results of the latest round of examinations demonstrated that the conduct in the Morgan Stanley case might have been prevalent throughout the mutual fund industry.

The officials said that 14 of 15 Wall Street brokerage houses the S.E.C. looked at had received cash from the funds, and that 10 of the 15 had received revenue-sharing payments in the form of commissions for trading stocks for the funds' portfolios.

The officials declined to identify any of the brokerage firms or funds, saying that they remained the subject of examinations and possible enforcement actions.

They said that their examinations found that only about half of the brokers disclosed their revenue-sharing arrangements at all, but that even in many of those instances, the disclosures appeared to have been inadequate.

Officials said the compensation to the brokers from the funds was typically for "shelf space" at the brokerage houses — meaning access to sales staff members, promotional material and inclusion on the brokers' recommended lists. The payments varied from 0.05 percent to 0.40 percent on sales, and up to 0.25 percent of the value of the investor's assets managed by the broker. In other words, for every $100,000 in new sales, the broker would receive $50 to $400 annually, and for every $100,000 that remained invested through the broker, the broker would receive up to $250 a year.

Mr. Cutler, the head of the enforcement division, said the examinations raised significant questions about the extent to which directors of the funds knew about the financial arrangements. He also read excerpts from several prospectuses of mutual funds that suggested they had not been sufficiently forthcoming.

Lori Richards, director of the commission's Office of Compliance Inspections and Examinations, summarized the matter. "The central issue is, does the customer know that a broker or registered representative has a conflict of interest?"