SEC TAKING HARD LOOK AT COZY DEALING BY FUND FIRMS COMMISSION SHARING FOR SALES UNDER SCRUTINY

The Securities and Exchange Commission is getting ready to slap the hands that scratch each other’s backs.

Mutual fund companies routinely funnel securities trades to the brokerages that are best at selling their funds, but the SEC is eyeing a challenge to that comfortable practice, says Barry Barbash, the head of the division that regulates mutual funds.

Speaking to InvestmentNews, Mr. Barbash, director of the SEC’s Division of Investment Management, says the agency’s enforcers are likely to look in the near future at the distribution mechanisms used, particularly in the fund business, to allocate investment company trades in exchange for selling fund shares, and at a practice called “stepping out of business.”

Enforcement cases likely would target load companies since the majority of such funds are sold through wirehouses like Merrill Lynch & Co. Inc., Smith Barney, PaineWebber Group and Morgan Stanley Dean Witter Inc. – all of which declined to comment.

In a widely used twist on the practice called stepping out of business, a fund company asks its broker to share some trading commissions with a broker that isn’t executing the trade. On either hand, the fund company is rewarding a particular brokerage for drumming up sales.

Harold Bradley, director of the equity trading desk at American Century Mutual Funds in Kansas City, Mo., which has $63 billion in assets in its no-load funds, believes the SEC should look more closely at the issue.

“Most of Wall Street is now stepping out of business,” he says.

The rule of thumb is that once a fund company earmarks brokerages offering the best execution at the lowest cost, it’s OK then to concentrate business with those on the list that are the top sellers of its funds. The practice is legal under SEC and National Association of Securities Dealers rules as long as it’s disclosed in prospectuses.

barbash cocks an eyebrow

But Mr. Barbash takes issue with fund firms using “a broker not necessarily because the broker is going
to get you the best price and execution on a security, but because the broker is selling fund shares.”

While he stresses he is “not suggesting that we’re seeing cases,” Mr. Barbash says this is “a very hot period of time for (fund) distribution. If you look historically at other hot periods of time for distribution, issues of allocation and brokerage by funds come up.”

Asked if he expects the SEC to bring enforcement action, he says: “It wouldn’t surprise me.” However, as a regulatory issue, he acknowledges it’s “probably one of the murkiest out there.”

Indeed, the most recent case brought by the SEC was in 1990, against Stein Roe & Farnham Inc. The agency charged that the Chicago money manager compiled a list of broker-dealer “friends of the firm” who had referred clients to the Stein Roe Funds and in return selected broker-dealers from the list. Stein Roe set target amounts for the fees it felt would compensate the brokers for their referrals, the SEC charged.

The practice violated the Investment Company Act of 1940, the SEC said, even though it didn’t result in higher commissions. Stein Roe settled without admitting or denying the findings by consenting to a censure and agreeing to establish internal controls.

Stein Roe officials did not return calls for comment.

Securities lawyers who represent mutual fund companies acknowledge that the issue is highly charged, and the industry trade group, the Investment Company Institute, would not comment, except to say fund firms are complying with regulations prescribed by the SEC and the NASD.

“This is one of the hottest issues in the whole industry right now,” says a lawyer with a large firm who represents mutual funds. “This is a bigger factor than soft dollars,” trades directed to certain brokers in exchange for research, computers and other goods and services. “This is a multimultibillion dollar business.”

At the end of September, mutual fund companies held 19% of e
quities traded on major U.S. exchanges, and had $2.4 trillion in stock fund assets at the end of January, according to the Investment Company Institute.

The problem for fund companies is that the SEC and NASD regulations are open to interpretation. Both forbid brokers or fund companies to demand business as a condition of doing business with each other. But they do allow fund firms to consider sales as one factor in determining who should make their trades.

Disclosure requirements are also weak. For mutual funds, the SEC has “extremely general disclosure requirements,” says the mutual fund lawyer. “You check a box (in one filing) if sales of fund shares are a factor in directing brokerage. But it’s very hard to gain any useful information from that.”

While any fund company could be affected, load funds are more likely targets than no-load funds, said Douglas Scheidt, chief counsel of the SEC’s Division of Investment Management. The case of Stein Roe, which sells mainly no-load funds, was an exception, involving investment advisory fees rather than commissions.

American Century’s Mr. Bradley says a brokerage’s willingness to share commissions with a competitor at the request of a fund company client “suggests spreads (between buying and selling prices of stocks) are too high … What we have right now in the commission structures on the buy side is a payment for order flow.”

sales immaterial

But Deborah Gatzek, general counsel of the Franklin Templeton Group, the nation’s second-largest load company (behind American Funds Distributors in Los Angeles) with $222 billion in assets, says the large houses the San Mateo, Calif., fund company uses to trade would probably be chosen whether or not they sell Franklin’s funds. “Goldman Sachs and Merrill Lynch make a lot of markets,” she says. “Given the realities of the market, (they are chosen for trades) because they do a good job rather than because they are selling fund shares. The funds are doing well for their c
lients. I think somebody may have a cart before the horse.”

At AIM Advisors Inc., a Houston-based load fund company with $83 billion in assets, whether a brokerage sells AIM Funds is one of many considerations but not the primary one. The “first consideration is whether you got best execution,” says Tim Cox, chief compliance officer. The company looks at whether there are other arrangements with the broker to receive research or specialized brokerage services, in addition to whether the broker sells AIM funds, he says.

There’s little indication that fund companies will change their ways.

“Distribution is always a crucial issue for any investment company,” says Jeremy Rubenstein, who represents mutual funds for the Washington law firm Wilmer Cutler & Pickering. “Open-end funds are by definition funds that have to stand ready to redeem their shares at a moment’s notice … It is inherent in the nature of the beast that a fund is susceptible to pressure by an organization that provides it access to new money.”

Maybe so, but the beast may soon be tamed by the SEC.