The Securities and Exchange Commission (SEC) is investigating eight brokerage firms and 12 mutual-fund companies for failing to disclose sales incentives that may have influenced advice to investors, an SEC official said.
SEC enforcement chief Stephen Cutler revealed the probes after an SEC examination of 15 brokerages found that 13 appear to have given favored treatment to mutual funds that shared revenue with brokers who sold those funds. The SEC didn’t identify the brokerage firms or fund companies.
“The customers don’t adequately understand the dimension of the conflict that they are facing,” Cutler said at a press briefing in Washington. “In particular, that the money being paid to incentivize brokerage firms is coming from the customer’s own assets, from the mutual funds themselves.”
The SEC and other regulators have been investigating improper sales practices in the $7.2 trillion mutual-fund industry, where about half of U.S. households invest.
Today, the SEC’s five commissioners plan to propose rules that would require brokers to tell customers at the point of sale about compensation the brokers receive from mutual-fund companies.
The new rules would “make sure that investors truly understand” the potential conflicts of interest a broker has when selling mutual funds, said Annette Nazareth, head of the SEC’s market-regulation division.
Investor advocates said the SEC’s findings show the practice of funds paying brokers is widespread. “Funds don’t compete to be bought; they compete to be sold,” Barbara Roper, director of investor protection with the nonprofit group Consumer Federation of America, said in an interview. “They do so in ways that drive costs to investors up and increase the likelihood that investors will buy inferior, more mediocre funds.”
Of the 15 brokerages inspected by the SEC, 14 were paid in cash and 10 accepted payments in the form of commissions on fund trades, SEC inspections director Lori Richards said.
The 13 brokerages that appeared to give preferential treatment to the funds often provided more prominent “shelf space” for the funds, such as listing them on the broker’s Web site or putting them on a list of preferred investments, Richards said.
Brokers were paid from $50 to $400 annually for every $100,000 they generated in new sales, Richards said. For every $100,000 that remained invested in the fund through the broker, the broker would receive up to $250 a year.
The SEC’s examinations also discovered only about half the brokerages told investors about the incentive arrangements, Richards said. “The disclosure varied from firm to firm and was not consistent,” she said.
Cutler said the enforcement investigations of the brokerage firms and mutual-fund companies were focused on inadequate disclosure. Cutler said the investigations also were looking at the role of mutual-fund directors.
“What did the boards of directors of the mutual funds here know?” Cutler said. “Did they know about these shelf-space payments?”
The SEC also is studying whether customers get the best execution of trades, Cutler said. In some cases, mutual funds were paying brokers extra commission for trades and then having the broker pass along some of that money to a second broker unconnected to the trade, Cutler said.
Along with the new disclosure plan, the SEC today will propose corporate-governance rules for mutual funds, including a requirement that mutual-fund boards be led by independent chairmen and have three-quarters independent directors, up from at least half, said Paul Roye, director of the SEC’s mutual-fund division.
Under the plan, independent directors would be allowed to hire staff and consultants to help them, Roye said.
The SEC brought its first enforcement case on mutual-fund sales practices in November against Morgan Stanley.
The firm, which did not admit or deny wrongdoing, paid $50 million to settle allegations it promoted the mutual funds of 16 companies in exchange for undisclosed payments.
Securities regulators also are investigating whether brokers failed to give customers volume discounts to which they were entitled.
SEC Chairman William Donaldson said in November that SEC enforcement staff notified a “significant number” of firms they could be sued for not passing on the discounts, known as “breakpoints.”
Mutual funds are also under scrutiny for allowing favored customers to make improper frequent trades in their funds at the expense of other shareholders.