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SEC Restricts Mutual Funds' Broker Rewards

The new rule bars asset managers from giving business to brokerages for promoting their investment offerings.

August 19, 2004|Walter Hamilton | Times Staff Writer

Federal regulators voted Wednesday to bar mutual fund companies from giving brokers lucrative trading business as an incentive to peddle their funds.

So-called directed brokerage arrangements have been criticized as thinly disguised kickbacks that inflate trading costs and encourage brokers to tout funds based on how much trading business they get, instead of recommending funds that are best for their clients.

The Securities and Exchange Commission voted 5 to 0 to ban the practice and separately voted to require fund companies to disclose more information on fund managers. It was the latest step aimed at ending conflicts of interest in the $7.6-trillion mutual fund industry.

"These conflicts are real," Commissioner Cynthia Glassman said at the SEC meeting in Washington. "They are widespread and have grown dramatically as the mutual fund industry has grown."

Even before the it banned directed brokerage arrangements, the SEC required that they be disclosed to investors. The agency is investigating possible violations related to fund sales at a number of companies. These include Los Angeles-based Capital Group Cos., manager of American Funds; Franklin Resources Inc. of San Mateo, Calif.; and PEA Capital in New York, the sister firm of Newport Beach-based Pacific Investment Management Co., or Pimco.

Capital, Franklin and PEA Capital have declined to discuss the SEC probe but have said they follow disclosure rules.

Mutual fund companies have resorted to rewarding brokers with trading business as a means of boosting sales.

In some cases, brokerages place funds on "preferred" lists solely because of the trading business they get. Shareholders might easily assume the recommendations are based on merit and not a business deal.

Brokerage giant Morgan Stanley agreed last year to pay $50 million to settle SEC allegations related to payments from 14 fund companies. Massachusetts Financial Services Co. agreed to pay $50 million to resolve a separate SEC probe.

Directed brokerage also pushes up trading costs because fund companies often pay above-market commissions to favored brokerages.

Banning directed brokerage won't eliminate all conflicts. Fund companies still can get preferential treatment by making "hard money" cash payments to brokerages. The new rule doesn't affect such payments, though the SEC staff is considering whether further reforms are necessary.

"The directed brokerage reform is a big one, but there are still bigger costs and bigger conflicts of interest that have yet to be addressed," said Russ Kinnel, director of fund research at Morningstar Inc. "Until they've cleared out all of those back-door payments so that brokers are selling purely on what's best for their clients, the SEC's job won't be done."

Paul Roye, head of the SEC's investment-management division, said a pending proposal would force fund companies to inform investors about hard-money arrangements when they buy funds.

"We are looking at the whole area of distribution and I can't tell you where we're going to go," Roye said. "At the very least, there would be disclosure about the payments and the incentives they create."

The ban on directed brokerage deals will take effect in about three months. In a separate action Wednesday, the commission voted to require fund companies to disclose new information about their portfolio managers, including how they determine their pay.

The disclosure is intended to help shareholders figure out whether managers are paid based on whether they improve the performance of the fund (which helps shareholders), or whether pay is for what they do to improve fund-company earnings, such as boosting assets.

"This is a really big win for fund investors because if anything's material it's got to be what the fund manager's incentives are," Kinnel said.

Fund groups also would have to reveal whether managers own stakes in their funds. In addition, companies would have to tell investors if managers handle other accounts, such as hedge funds, that could create a conflict.

Finally, investors would receive detailed information about the top five people responsible for the investment decisions of each fund.

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