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Brokers Get Fees To Push Funds

SEC probe finds investors not told firms were paid

Jan 14, 2004 | Los Angeles Times Wall Street brokerages routinely base their mutual-fund recommendations on undisclosed payments from fund companies rather than on what's best for their clients, regulators said Tuesday.

In the latest indication of widespread abuses in the fund industry, a Securities and Exchange Commission survey of 15 large brokerages found that 13 of the firms appeared to give preferential treatment to fund companies that paid them. The firms used a variety of techniques, the SEC said, such as highlighting the funds on brokerage Web sites or featuring them on so-called recommended lists used by brokers to peddle funds to clients.

Such payments are not illegal but must be fully disclosed to investors. The SEC said Tuesday that it is investigating whether eight of the brokerages and a dozen fund companies broke federal securities laws by not properly disclosing the payments. SEC officials refused to identify the firms.

The payments, known as revenue-sharing deals, have become a key focus for regulators in their broader crackdown on the fund industry, in part because the financial harm to investors is thought to dwarf the losses caused by the improper fund trading that has been the focal point of investigators until now.

Critics say the arrangements are one of the most egregious practices in the fund business because they often give brokers a hidden incentive to recommend funds that pay them the most, rather than those that have the best investment returns.

"As an investor, you're getting put into 'XYZ Internet Fund' or whatever simply because your broker is getting paid to push it," said Henry Hu, a securities-law professor at the University of Texas. "That can be a real disaster if you're put into an inappropriate fund."

As part of a series of initiatives to be unveiled Wednesday, the SEC will propose new rules dealing with revenue sharing, including requiring brokers to clearly tell customers about the payments.

"It's quite a high priority for us," said Lori Richards, director of the SEC's Office of Compliance Inspections and Examinations.

Among the other SEC proposals are several that could meet stiff resistance from the fund industry. One would force funds to give investors information comparing their expenses with those of competitors. The commission also is expected to vote on rules that would require fund-company boards of directors to be more independent.

Revenue sharing has become rampant in recent years as investor defections caused by the recent bear market made fund companies desperate to find new customers.

Like some of the other illicit practices turned up in the 5-month-old fund scandal, revenue sharing long has been an open secret in the fund industry, yet it was virtually unknown to individual investors and under little regulatory scrutiny until recently.

Revenue sharing broke into the spotlight in November when brokerage giant Morgan Stanley agreed to pay $50 million to settle SEC charges that the firm failed to tell investors about payments it received for selling mutual funds from a relative handful of large fund companies.

Revenue sharing comes in two forms.

Some fund companies pay cash known as "hard money" to brokerages. Others send lucrative stock-trading business known as directed brokerage to the firms. Fourteen of the 15 brokerages surveyed by the SEC received cash and 10 got trading business.

Many critics say directed brokerage is the more deceitful and costly practice. Funds that direct trading to specified brokerages have little motivation to keep trading commissions low, and may have incentives to overpay.

Those costs are passed on to investors and can reduce fund returns. But shareholders can't avoid the trading costs or even determine how much they're paying. That's because trading fees are excluded from a fund's so-called expense ratio, the industry's official fee measurement.

The SEC staff may propose barring directed brokerage, said Paul Roye, the SEC's investment-management chief.

Some fund companies defend directed brokerage by saying that as long as they get the best available prices when buying stocks there's nothing wrong with using firms that promote their funds. Nevertheless, the Investment Company Institute, the fund industry's main trade group, recently recommended that the practice be outlawed because of the potential conflict of interest.

When Morgan Stanley settled with the SEC, it agreed to disclose more about the payments it gets from fund companies in its so-called Partners Program. The SEC said it would look into the sales practices at 14 fund firms that were members of the program, including Fidelity Investments and Putnam Investments.

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