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SEC Probe of Fund Sales Practices Shows Widespread Abuses

Jan 13, 2004 | Wall Street Journal

Mutual funds commonly pay brokers for promoting their shares but investors may not be aware of the practice known as "revenue sharing," regulators said Tuesday.

Recent examinations by the Securities and Exchange Commission found 14 out of 15 brokers received cash payments for selling mutual funds and 13 of the 15 seemed to have favored funds making such payments. Fund advisors also sometimes reward brokers for featuring their funds by directing brokerage trades to them, the SEC found.

About half of the brokerage firms paid brokers more for selling their own in- house funds or funds with who they had revenue sharing agreements, the SEC also found.

Selling a new $100,000 fund investment might generate $50 to $400 to a broker and provide up to $250 a year thereafter if the investor stayed in the preferred fund, according to the SEC.

While about half of the brokerage firms surveyed disclosed the payments, the SEC said it isn't clear whether investors are adequately informed about conflicts of interest that might occur when a broker is paid to favor certain mutual funds over others.

Stephen Cutler, the SEC's director of enforcement, said the agency currently has eight active investigations of broker-dealers and 12 investigations into mutual-fund families for failing to adequately inform investors of the revenue- sharing deals.

Mr. Cutler said the agency has seen several cases where a fund firm discloses that it may use its own funds or resources to pay additional commissions to broker dealers, but a lack of disclosure regarding the use of investors' money to pay brokers who favor the fund over others.

The SEC will also look into what the fund directors knew about the revenue- sharing plans and any liability they may have for the lack of disclosure, Mr. Cutler said.

Best execution, or obtaining transactions at the best price in a timely manner, concerns are also raised by revenue-sharing plans, Mr. Cutler added.

Mutual fund directors could be on the spot if they approved suspect revenue- sharing deals, SEC officials said.

SEC officials declined to identify which fund companies and brokerage firms are under investigation for potential violations stemming from revenue-sharing arrangements. But they didn't rule out chances that some mutual funds in hot water for abusive trading practices could face further legal problems for revenue-sharing arrangements with brokers.

Although the NASD permits mutual fund firms to consider brokerage sales when routing brokerage orders, it doesn't allow favoritism in exchange for sales, regulators stressed.

"The NASD does not bless these arrangements in any way, shape or form," said Mr. Cutler, the SEC enforcement division director.

The NASD is probing more than 50 revenue-sharing deals, and the SEC is following up with dozens of companies, according to Lori Richards, head of the SEC's office of inspections, examinations and compliance.

Ms. Richards said the 15 brokerage firms examined by the SEC include a mix of large, medium and small firms, giving regulators a good look at practices on Wall Street and elsewhere. Based on findings so far, she said revenue-sharing agreements appear to be "widespread industry practice."

While practices and disclosure varied from firm to firm, Mr. Cutler said he firmly believes "the customer has a right to know" about such deals when buying a broker-sold mutual fund.

Making the case may be harder. Brokerage firms aren't obligated to divulge revenue-sharing arrangements if the fund company discloses them, so in such cases, it isn't clear whether the SEC could bring a fraud claim against the brokerage company.

"We're actively investigating that," said Ms. Richards.

Enforcement isn't the only tool regulators plan to use to combat problems involving revenue-sharing deals. The SEC meets Wednesday to consider changes to strengthen fund governance and require fund companies to adopt a far-reaching code of ethics, noted SEC investment management division director Paul Roye.

Better disclosure also is on the table. SEC market regulation division director Annette Nazareth said the SEC will consider plans for brokerage firms to provide point-of-sale information telling fund investors if the firm receives cash or brokerage business for selling funds, or provides special payments to brokers who sell certain funds.

In addition, the SEC will propose a new confirmation statement for mutual fund investors. Regulators say the statement would detail specific payments to the broker and brokerage firm who sold the fund.

Investors might get more details such as how fees for broker-sold funds stack up to the rest of the fund industry. Nazareth said such information might be very useful to investors, but cautioned that it might take a while for such disclosure to appear, as there is currently no database of fund fees across the $7 trillion industry.

If approved, the new disclosure would be available for investors in mutual funds, including 529 college saving plans and variable annuities.

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