Mutual Fund Firm Payments Targeted

Wall Street brokerage firms routinely base their mutual fund recommendations on undisclosed payments from fund companies rather than on what’s best for their clients, regulators said Tuesday.

In the latest indication that there are widespread abuses in the fund industry, a Securities and Exchange Commission survey of 15 large brokerages found that 13 of them appeared to give preferential treatment to fund companies that paid them, the SEC said. The brokerages used a variety of techniques, the agency said, such as highlighting the funds on websites or featuring them on so-called recommended lists used by brokers to peddle funds to clients.

The payments in question aren’t illegal but must be fully disclosed to investors. The SEC said Tuesday that it was investigating whether eight brokerages and a dozen fund companies broke federal securities laws by not properly disclosing the payments. SEC officials declined to identify the firms.

Known as revenue-sharing deals, the payments have become a focus for regulators in their broader crackdown on the fund industry, partly because the financial harm to investors is thought to dwarf the losses caused by the improper fund trading that has until now been the focal point for investigators.

Critics say the deals are among the most egregious practices in the fund business because they often give brokers hidden incentives to recommend funds that pay them the most, rather than those that have the best investment returns.

“As an investor, you’re getting put into ‘XYZ Internet Fund’ or whatever simply because your broker is getting paid to push it,” said Henry Hu, a securities law professor at the University of Texas. “That can be a real disaster if you’re put into an inappropriate fund.”

As part of a series of initiatives to be unveiled today, the SEC will propose rules dealing with revenue sharing, including requiring brokers to clearly tell customers about the payments.

“It’s quite a high priority for us,” said Lori Richards, director of the SEC’s Office of Compliance Inspections and Examinations.

Among the other SEC proposals are several that could meet stiff resistance from the industry. One would force funds to give investors information comparing their expenses with those of rivals. The commission also is expected to vote on rules that would require the boards of fund firms to be more independent.

Revenue sharing has become rampant in recent years as investor defections caused by the recent bear market made fund firms desperate for new clients.

Like some of the other questionable practices turned up by investigators in the last five months, revenue sharing long has been an open secret in the fund industry, yet it was virtually unknown to individual investors and under little regulatory scrutiny until last spring.

Revenue sharing broke into the spotlight in November when brokerage giant Morgan Stanley agreed to pay $50 million to settle SEC charges that the firm failed to tell investors about payments it received for selling mutual funds from a relative handful of large fund companies.

“This is the stuff that really weakens the system,” said Don Phillips, a principal at fund research firm Morningstar Inc. in Chicago.

Revenue sharing comes in two forms.

Some fund companies pay cash, known as “hard money,” to brokerages. Others send lucrative stock trading business, known as directed brokerage, to the firms. Fourteen of the 15 brokerages surveyed by the SEC received cash, and 10 garnered trading business.

Many critics say directed brokerage is the more deceitful and costly practice. Funds that direct trading to specified brokerages have little motivation to keep trading commissions low and may have incentives to overpay.

Those costs are passed on to investors and can reduce fund returns. But shareholders can’t avoid the trading costs or even determine how much they’re paying. That’s because trading fees are excluded from a fund’s so-called expense ratio, the industry’s official fee measurement.

The SEC staff may propose barring directed brokerage, said Paul Roye, the SEC’s investment-management chief.

Some fund companies defend directed brokerage by saying that as long as they get the best available prices when buying stocks there’s nothing wrong with using firms that promote their funds. Nevertheless, the Investment Company Institute, the fund industry’s main trade group, recently recommended that the practice be outlawed because of the potential conflict of interest.

When Morgan Stanley settled with the SEC, it agreed to disclose more about the cash payments it receives from fund companies in its so-called Partners Program. The SEC at that time said it would look into the sales practices at 14 fund firms that were members of the program, including Fidelity Investments, Putnam Investments, Pimco Funds of Newport Beach and Capital Research & Management Co. of Los Angeles, which runs the American Funds group and has since dropped out of the program.

Morgan Stanley now discloses revenue sharing arrangements on its website. The firm says it receives an upfront payment of as much as $20 per $10,000 of shares sold in funds in the partners program. Also, for as long as an investor holds the funds, the brokerage each year receives as much as $5 per $10,000 invested.

The amounts are tiny compared with the commissions investors pay when they buy some funds, which may be 5% or more of the purchase amount. Moreover, the revenue-sharing fees are supposed to be paid by the mutual fund management company, and aren’t supposed to be borne by fund shareholders.

Still, industry experts say the amounts add up for brokerages, given the tens of billions of dollars of fund shares sold each year.

Fund companies typically disclose revenue-sharing deals in the prospectuses they send to prospective investors, but the disclosures are usually murky and all but impossible for small investors to understand.

For example, the prospectus for one of Capital Research’s funds says the fund’s distributor “may pay or sponsor informational meetings for dealers as described in the statement of additional information.”

The fund industry has been under siege since New York Atty. Gen. Eliot Spitzer revealed in early September that he had found evidence of improper trading practices at several fund firms.

The industry has tried desperately to cap the scandal, but new revelations arrive almost weekly. And critics say revenue sharing could do the most harm to the industry’s image because it seems to be accepted operating procedure at many firms. “Does it do your image good if you’re basically paying for recommendations?” the University of Texas’ Hu said.

Times staff writers Josh Friedman and Tom Petruno contributed to this report.