Funds Have Company in Scandal Blame Game

Great financial scandals often are like oil spills: They spread far beyond their center and leave a nasty residue that can take years to clean up.

So it is with the mutual fund industry scandal. It began in September with revelations of trading misdeeds, but now virtually all aspects of the business are under scrutiny. And abuses appear to be everywhere -- for example, in the actions (or inactions) of fund directors, in the management fees charged to shareholders and, by last week, in the agreements many fund companies have with brokerages to tout specific fund shares.

You didn’t know that your mutual fund could cut sales deals with brokerages? You probably couldn’t know, given how little interest the funds and the brokerages have had in publicizing such pacts.

The Securities and Exchange Commission certainly knew, yet it hasn’t made much of an effort to delve into the issue until recently.

Now, of course, everyone is interested in attacking mutual fund practices. Half the state treasurers in the country may wind up running for governor based partly on how aggressively they’ve assailed the industry.

The funds brought this on themselves, but the blame they’re getting on some counts is misdirected. The brokerage industry arguably bears the bulk of the responsibility for some of the abuses laid at the funds’ door.

In the latest regulatory salvo, the SEC last week said it found that 13 of 15 major brokerages it examined appeared to emphasize sales of funds that made special payments to the firms. The agency said it was investigating whether fraud had been committed.

The practice is called “pay to play,” and right away an investor ought to see the problem: Your broker could be recommending a fund for your portfolio based more on the financial reward he or his firm receives than on whether the fund is the best investment for you.

The extent to which small investors were hurt by fund trading abuses, such as market timing, remains a matter of great debate. But if your broker willfully sold you a fund that was inappropriate or simply inferior to others available, the harm would be measurable and irrefutable.

How did special sales relationships develop between fund companies and brokerages? The fund industry’s explosive growth during the last 10 years made such tie-ins all but inevitable, because of the sheer number of funds competing for investors’ dollars.

There are more than 8,000 stock, bond and money market fund portfolios in the marketplace, compared with 3,000 in 1990, according to the Investment Company Institute, the funds’ chief trade group.

Moreover, since 1990 the percentage of individual investors who buy funds on their own has shrunk significantly. Most people seek the help of a broker or other financial advisor, or buy from among the limited menu of funds in their company-sponsored retirement plans.

The share of fund sales made through brokers or other intermediaries was 87% in 2002, compared with 77% in 1990.

Brokerage firms are in the business of spotting profit opportunities, and they saw one as mutual fund companies jockeyed for investors’ attention.

A report issued in December by Cerulli Associates, a Boston-based financial services research firm, described how the generic practice of “revenue sharing” between fund companies and brokerages grew over the last decade or so.

Initially, the report said, a brokerage would ask a mutual fund company for a $10,000 to $20,000 “support check” to defray the cost of holding a regional meeting of brokers, at which the fund company would promote the merits of its products.

That practice quickly gave way to expected yearly support payments to brokerages from fund companies that wanted their portfolios to get noticed, Cerulli said.

“Preferred lists” then began to develop: A brokerage would tell its sales force that a relative handful of fund firms should get particular attention when a broker was looking for portfolios that fill customers’ needs.

Not surprisingly, the fund companies on the preferred list were those that agreed to pay a certain level of support fees to the brokerage. The brokers knew it. And if they cared about their jobs, they’d probably think first about those funds.

There are two ways to describe such payments, and both smell bad, said Don Phillips, a principal at fund research firm Morningstar Inc. in Chicago: They’re either bribes by mutual fund companies to spur sales, or they’re blackmail by the brokerages to do the same.

But are the payments illegal? They aren’t if they’re properly disclosed, at least under current SEC rules. What constitutes proper disclosure is the issue.

Many fund firms have described the payments in only the most general terms in fund prospectuses. And it’s highly unlikely that many investors bother to read that fine print.

A key question in the matter of revenue sharing is whose money is involved. One way the payments have been made is through so-called directed brokerage. That’s when a fund manager decides which brokerages should be picked to execute securities transactions for the fund portfolio based in part on how well the brokerages have sold shares of the fund.

Because securities trades are paid for out of portfolio assets, they’re a direct expense of a fund’s investors. So if a favored brokerage charges a higher commission than a non-favored brokerage, fund investors are hurt.

The fund industry has recognized the mess it’s in with directed brokerage. The Investment Company Institute recently decided to recommend that the SEC ban the practice.

But the institute isn’t arguing against another form of sales-spurring revenue sharing: cash payments made to brokerages from fund management companies -- meaning money that doesn’t come directly from individual fund portfolios.

The cash amounts that fund companies pay to be on brokerage “preferred lists” may seem small at first glance. The Cerulli report pegged them at $20 to $25 in upfront payments per $10,000 of fund share sales, and a continuing annual payment of up to $5 per $10,000 of fund assets held by a brokerage’s customers.

Fund companies such as Los Angeles-based Capital Research & Management Co., parent of the American funds, say such payments are legitimate because they defray the cost of informing brokers about funds.

“We don’t think it’s unfair to share in the cost of educating brokers,” said Paul Haaga, a senior officer at Capital Research and current chairman of the Investment Company Institute.

But he concedes that, even if a fund firm is making such payments from its own assets rather than from shareholders’ assets, investors could wonder if the fund management fee they’re paying the firm might be higher to make up for the payments.

“How do we know the management fee wouldn’t be lower without it? It’s a perfectly legitimate question,” Haaga said.

Nonetheless, most industry analysts don’t expect fund “preferred lists,” or revenue sharing, to go away. At best, the SEC is likely to default to its usual remedy: more disclosure.

Yet many industry analysts say the onus for disclosure shouldn’t be on the funds, but rather on brokers. They’re picking the funds; they should be telling the customer everything that affected the decision, including revenue-sharing payments.

“Investors are entitled to know if what they’re buying is an unblemished recommendation,” said Burton Greenwald, head of fund research firm B.J. Greenwald Associates in Philadelphia.

Annual surveys by the Securities Industry Assn. show investors have increasingly worried that their brokers face inherent conflicts of interest.

How right they are to worry.

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Tom Petruno can be reached at tom.petruno@latimes.com.