SEC Steps to Plate in Fund Scandal

The Securities and Exchange Commission was forced to take a back seat to New York Atty. Gen. Eliot Spitzer in the first phase of the mutual fund industry cleanup.

In the second and probably final phase, however, the SEC appears to be reasserting its role as the fund industry’s principal regulator -- and is under heavy pressure to show that it can be just as tough as Spitzer.

And that may be bad news for California’s three biggest mutual fund companies, whose business practices are a key focus of the SEC’s investigation.

The agency has for months been examining Los Angeles-based Capital Group Cos., the parent of American Funds; San Mateo-based Franklin Resources Inc., which manages the Franklin and Templeton funds; and bond fund giant Pacific Investment Management Co., the Newport Beach firm known as Pimco that is a unit of German insurance company Allianz.

The common denominator in these investigations, and in continuing SEC probes of other fund companies, is the issue of “pay to play” -- a term the fund industry hates but that aptly describes the relationships many of the companies have had with the brokerages that sell their funds.

Pay to play, or revenue sharing, refers to payments made by fund companies to brokerages for the purpose of promoting fund sales. These payments, which have become common practice over the last decade, can be in hard money or in so-called soft dollars, such as commission-generating stock or bond trades that a fund firm sends a brokerage to execute.

The existence of these agreements, and the potential conflicts of interest they pose, have been a revelation to many investors, but not to the SEC. The agency knew about revenue sharing and was OK with the concept. Fund companies were just supposed to be sure they disclosed the basics of the agreements to investors, even if that disclosure was in documents most investors never see.

As often happens when scandal hits, however, practices that once were OK suddenly can come to be viewed as outrageously bad conduct. After Spitzer trumped the SEC in September by uncovering shocking cases of “market timing” and other trading abuses in fund shares by favored investors, some industry critics said pay to play was a much bigger problem waiting to be exposed and meaningfully reformed.

The wait may soon be over. Fund industry executives are bracing for the SEC to announce a pay-to-play case against a major fund company. Many executives believe the target will be Franklin Resources, which is the fourth-largest fund firm in terms of stock and bond assets and manages $351 billion in all.

The Franklin case has developed an interesting twist: Industry sources say that Franklin over the last month or so has canvassed other fund companies about trying to arrange an industrywide settlement of pay-to-play issues with the SEC.

Such a settlement would allow Franklin to avoid being singled out for alleged conflicts of interest or inadequate disclosure in its revenue-sharing practices. Instead, it would be one of many fund companies suffering a public lashing over these issues.

The idea has precedent: In 2002, 10 of Wall Street’s biggest brokerages agreed to a universal settlement with Spitzer and the SEC over allegations of widespread deceptive practices involving analysts’ research opinions on stocks.

Franklin has confirmed to its shareholders that it is being investigated, but beyond that the company has declined comment about its case.

The SEC, as is its custom, declined to comment on its investigations.

Within the industry, however, the SEC’s approach in its pay-to-play probe, and how aggressive it might decide to be in alleging wrongdoing by fund companies, is a hot topic.

There is a widespread view that the SEC feels the need to prove to the industry, Congress and the public that it’s a vigilant regulator, after Spitzer suggested otherwise in his initial salvos against fund companies on abusive trading arrangements.

“The SEC already has been found guilty, in the court of public opinion, that they weren’t tough enough” as a fund cop, said Don Phillips, a principal at fund rating firm Morningstar Inc. in Chicago.

Privately, some fund industry executives say the SEC’s desire to burnish its image shows in the attitude of agency staff attorneys who are on the front lines of the pay-to-play probe. It is clear, the executives say, that the SEC staff wants to prove significant wrongdoing.

“If you’re an SEC attorney this could propel your career for 20 years,” said one fund executive, who requested anonymity.

Yet some current and former SEC officials say that proving fraud in pay-to-play practices is no easy task.

For investors, it isn’t difficult to see the potential conflicts of interest such payments pose: Did your broker sell you a particular mutual fund because it was the best choice for you -- or because of the extra compensation it would mean for his or her firm?

But the SEC faces a sea of gray, rather than black-or-white choices, in alleging that laws were broken.

For example, the agency’s policy has long been that a fund company could take into account a brokerage’s sales of the firm’s funds in deciding whether to direct commission-producing securities trades to the brokerage as a form of compensation.

However, the overriding issue in how a fund company directs its securities trades is supposed to be the “best execution” test -- in other words, trades should go to brokers based on how good a price they can get for a security, and how competitive their commissions are.

Best execution is paramount because trading costs are deducted from fund assets; that’s shareholders’ money.

So the SEC must carefully dissect a fund company’s trading history with brokerages and compare those trades with the level of fund shares the brokerage sold, to determine whether there’s a connection that suggests that the best-execution requirement was ignored.

The SEC also could try to show that fund companies fell short in their disclosure to investors of brokerage pay-to-play arrangements. This, too, is a gray area. Many fund executives have argued that it’s grossly unfair for the SEC to now judge that disclosure has been inadequate, when the agency signed off on those disclosure documents for years.

But the agency may have found a way around that obstacle: In the only fund company case the SEC has brought so far on pay-to-play issues, it alleged in March that Massachusetts Financial Services Co. committed fraud by failing to disclose the conflicts of interest that could arise from its revenue-sharing deals with brokerages. MFS settled without admitting or denying guilt.

Since that case, which got relatively little publicity, the assumption in the fund industry has been either that the SEC would bring similar or perhaps more aggressive cases against substantially larger fund companies, or that it would simply opt to write sweeping new rules to govern revenue-sharing arrangements.

The idea of an industrywide agreement effectively conceding that pay-to-play deals have been rife with conflict, and that the practices would be reformed, makes more sense than having the SEC spend enormous resources bringing multiple cases against individual fund companies, some securities lawyers say.

“I don’t see any reason why the concept of getting everyone to the table would be something the SEC should reject out of hand,” said one lawyer representing a fund company, who spoke on condition of anonymity.

Many fund industry executives, however, believe that the agency is intent on reeling in one or more big fish on pay to play, to send a message not only to the industry but to other constituents as well -- including Congress, which has taken plenty of shots at the SEC since Spitzer upstaged it by exposing the trading abuses.

Franklin, Capital Group and Pimco all qualify as very big fish; Capital is the nation’s third-biggest fund firm; Pimco ranks fifth.

The SEC faces another consideration in its investigation: California Atty. Gen. Bill Lockyer’s staff also is investigating Franklin, Capital Group and Pimco for potential abuses under pay-to-play practices, and whether the companies’ disclosure of those deals was inadequate under state law.

The SEC staff and Lockyer’s staff have been working together in the probes.

What the SEC surely doesn’t want, fund industry observers say, is to face another situation in which it is outshone by a state attorney general. That, too, suggests that the agency is likely to bring some high-profile fund companies to public account on revenue-sharing practices.

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