SEC Staff Seeks Ban on Funds’ Extra Payments to Brokerages

The Securities and Exchange Commission staff will recommend barring mutual fund companies from paying higher trading commissions to brokerages for promoting the companies’ funds, a senior agency executive said Thursday.

“This is an area where we think the conflicts are such that we ought to ban ‘directed brokerage,’ ” SEC mutual fund chief Paul Roye said of the incentive payments. “What our examinations reveal is there are explicit quid pro quo arrangements.”

The proposal to end the payments comes after an SEC review found that securities firms appeared to favor funds that have engaged in “revenue sharing” with brokers. Such incentives often weren’t disclosed to investors, Roye said.

Specifically, the SEC is investigating eight brokerages and 12 fund companies for directed-brokerage practices.

Mutual funds pay directed-brokerage incentives by steering their securities trades to brokers who promote the companies’ funds, and paying them an increased commission, usually 5 cents a share instead of 2 cents.

That cost is borne by fund shareholders, because commission costs are taken directly from fund assets. Investors have no way to measure such costs because fund firms aren’t required to itemize excess commissions in financial statements.

In some cases, fund companies direct a broker to pass the extra commission to another brokerage that wasn’t involved in the transaction but promotes the company’s funds.

Aside from potential conflicts of interest for brokers, Roye said directed-brokerage payments raise questions about whether mutual funds are fulfilling their duty to get the best execution for their customers’ trades.

Congress also is looking at how fund companies pay brokers.

“These hidden practices raise troubling conflict-of-interest concerns that need to be ended,” said Sen. Carl Levin, a Michigan Democrat, at a hearing on fund fees earlier this week.

The SEC staff will submit the proposed ban on directed-brokerage incentives for a vote of the five-member commission Feb. 11, Roye said.

“Directed brokerage creates harm in terms of its lack of transparency and interferes with the integrity and efficiency of the market,” said Harvey Goldschmid, one of two Democrats on the SEC.

The Investment Company Institute, the funds’ chief trade group, has supported a ban on directed brokerage.

But the trade group hasn’t supported the idea of ending all incentive payments from mutual funds to brokerages. Many fund firms make cash payments to brokers based on fund sales.

An SEC examination last year found that 13 of 15 brokerages inspected gave preferential treatment to mutual funds that made incentive payments. The brokerages often provided more prominent “shelf space” for the funds, such as listing them on the brokerage’s website or putting them on a list of “preferred” investments, the SEC has said.

The agency’s examination also discovered that only about half the brokerages told investors about the incentive arrangements.

Franklin Resources Inc., the fourth-biggest U.S. fund company, and Putnam Investments, the sixth-largest, recently said they would stop making directed-brokerage trades. John Hill, head of Putnam’s board of trustees, said the incentives were costing shareholders $30 million to $40 million a year in extra expenses.