Regulators’ scouring of the mutual fund industry moved in a new direction Monday, as Morgan Stanley agreed to pay $50 million to settle federal charges that it accepted higher fees in return for pushing some funds.
In other scandal news, Bear Stearns reportedly fired brokers over trading practices, while Alliance Capital Management said it will delay its Q3 report due to a charge it’s taking related to the fund probe.
And Putnam Investments, which settled SEC charges last week, said the $7 billion in assets it lost due to fund shareholder redemptions last week was down from $14 billion the week before. Putnam’s assets plunged 8% the past two weeks to $256 billion.
Morgan Stanley’s charges were unrelated to late trading and market timing that other firms faced.
“Morgan Stanley was making buy recommendations to customers without adequately disclosing upfront that those shares could be subject to higher annual fees,” said Merri Jo Gillette, a Securities and Exchange Commission associate director of enforcement.
The settlement with the brokerage giant also involved charges that Morgan Stanley didn’t properly disclose to investors the inner workings of its distribution system. In particular, regulators found fault with a practice in which funds were charged to be in its so-called Partners program.
“That involved Morgan Stanley putting certain funds onto a preferred recommendation list,” said Gillette. “It gave those funds on the list higher visibility with the Morgan Stanley sales force.”
In some cases, says the SEC and NASD, brokers were also rewarded with extra fees. Those could amount to anywhere from 15 to 25 basis points tacked onto the cost of each transaction, depending on size and time of each deal.
“We felt these problems with Morgan Stanley were so firm-wide,” said Gillette, “that rather than bring charges against individuals we charged the entire brokerage firm.”
Morgan Stanley favored funds offered by up to 16 fund companies, out of some 115 that its sales force could sell, regulators said.
In settling charges, Morgan Stanley didn’t admit to any wrongdoing. But it agreed to make policy changes and create guidelines to better inform investors. It said it would no longer accept soft-dollar payments on retail sales of funds. Soft-dollar payments are made in the form of commission business rather than cash.
“I regret that some of our sales and disclosure practices have been found inadequate,” said Philip Purcell, Morgan Stanley’s chief executive, in a statement. “We will act quickly to implement the terms of the settlement.”
In September, Morgan Stanley paid $2 million to settle NASD charges that it offered bonuses to brokers who sold the company’s own mutual funds rather than third-party funds.
The spreading scandal in the $7 trillion industry appears to be moving into a new phase. The SEC and NASD, which negotiated the latest settlement, say more cases over retail marketing practices are pending.
New York Attorney General Eliot Spitzer, who launched the fund probe in September, said it will expand to include soft-dollar payments and fund fees.
“This scandal started out in September looking at trading privileges given to preferred customers and insiders,” said Rick Ferri, an independent money manager. “Now, we’re seeing a shift as regulators seem to be digging into how mutual funds are being sold and marketed to mainstream investors.”
The SEC and others, he says, shouldn’t have to look too far. “What Morgan Stanley’s being charged with are practices that everyone’s been doing for years,” said Ferri, a former Wall Street broker. “It’s a big part of the way brokerage firms make their money distributing mutual funds.”
Bear Stearns could also be facing regulators’ wrath. It reportedly fired four brokers and two others in its sales force last week in connection with the funds scandal. The company didn’t respond to phone calls by press time Monday seeking comment.
Alliance blamed the delay in its third-quarter report on a $190 million charge it’s taking in anticipation of possible allegations related to the fund scandal. Spitzer and the SEC are both investigating the firm.
Ferri, who now manages $220 million for institutional and high net-worth investors, said industry buzz is that the way IPOs were handled by mutual fund companies is sure to be the scandal’s next target.
Gillette said the SEC has looked into IPOs, but declined to give further information.
In particular, investigators are believed to be interested in how funds were allotted shares in hot IPO stocks during the tech boom.
“When a fund company puts in for a certain number of shares of stock, they don’t necessarily have to allocate those shares to its funds until the end of the day,” said Ferri. “They can wait to see what happens.”
When shares took off, he said, some funds complained to insiders that rivals were channeling most of those IPOs to smaller funds.
“That way, they could pump up performance more dramatically to shareholders than if they allocated more equally to larger funds,” said Ferri.
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