SEC takes mutual fund industry to task

Agency finds many firms had disclosure problems

January 14, 2004|By Paul Adams and Eileen Ambrose | Paul Adams and Eileen Ambrose,SUN STAFF

The mutual fund industry was hammered yesterday by the Securities and Exchange Commission for paying Wall Street brokerage firms to recommend their products -- frequently without telling investors.

SEC officials said the agency had discovered many instances where brokerages failed to disclose payments from mutual fund companies whose funds they recommended.

They compared the practice to the conflicts of interest that existed during the recent stock market boom when securities analysts failed to reveal their firms' relationships with the companies whose stocks they promoted.

SEC representatives said they were currently investigating the disclosure practices of 20 mutual funds and securities firms and expected their investigative effort to expand to cover many more. They declined to name the firms under investigation.

The SEC is expected to consider new rules today that would require mutual fund companies to increase their disclosures to investors and to weigh reforms to trading practices that are considered unfair to small investors.

The SEC revelations appear to reflect an effort by the agency to regain a leadership role in regulating funds, after a series of high-profile prosecutions by New York Attorney General Eliot Spitzer that have shaken public confidence in the industry.

More than 95 millions Americans depend on mutual funds in part for their financial security.

Mutual fund insiders said the practice of paying brokerage firms to promote specific funds was widely known within the industry but went largely unnoticed by the SEC until recently.

The promotions themselves are not illegal, but failing to adequately disclose the arrangements to investors is a clear violation of laws designed to protect them.

"It's been going on probably forever," said John C. Bogle, founder of the Vanguard Mutual Fund Group and industry critic. "It gives an unhealthy incentive for these brokers to sell the funds that firms were paying them for."

"Airing all this out and getting disclosure is the right remedy," said George L. Perry, a senior fellow of economic studies at the Brookings Institution.

But Gary Gensler, co-author of The Great Mutual Fund Trap and a former senior Treasury Department official, said disclosure of the marketing payments probably won't be much help to small investors.

"Its about time the SEC highlights this problem," Gensler said. "It's a real conflict of interest."

SEC Chairman William H. Donaldson warned mutual fund directors in a speech last week that they may become targets of reform efforts.

At issue is the question of whether the mutual fund boards are adequately policing the marketing practices and fee arrangements of the funds they are overseeing.

"The circumstances that we are investigating reflect a serious breakdown in management controls in more than a few mutual fund complexes," Donaldson said.

"The breakdown ... raises troubling questions about the ability of many fund boards, as presently constituted, to effectively oversee the management of funds," he said.

The SEC signaled its tough new attitude on disclosure two months ago when it fined Morgan Stanley, one of the nation's largest retail brokers, $50 million for not telling investors enough about payments made to its brokers to push certain funds.

The payments were noted in fund prospectuses, but that wasn't enough to satisfy the SEC.

Eric Leo, who recently retired as head of equity investments at MTB Investment Advisors in Baltimore, called fund payments to brokerages unfair.

"It hurt smaller and mid-size mutual fund companies, like ourselves," Leo said.

Brokers are less interested in promoting the fund of small companies that can't afford the same type of compensation, "even though it might be a perfectly good fund," Leo said.

"My sense is that as time went on, more and more firms started to do this," Leo said. "Once that ball starts rolling down the hill, it picks up more and more."

James S. Riepe, vice chairman of Baltimore-based T. Rowe Price Associates, said such practices are not an issue for his firm because it sells its funds directly to investors.

"What they are saying is if a broker says, `Here's 10 funds for you to consider,' does this investor know that those are from fund groups that paid an extra 10 basis point to be on the select list? That's the question," Riepe said. "The SEC is saying it's something that investors need to know.

"I'm sure the disclosure can be improved. There is no question about that," Riepe said.

Meg VanDeWeghe, an executive-in-residence at the University of Maryland, College Park and a former managing director at J.P. Morgan, said investors weren't necessarily hurt by the hidden payments.

"It doesn't matter if they are suggesting a fund because they are getting compensation in soft dollars as long as it's a good investment for the investor," she said.

But SEC Enforcement Director Stephen M. Cutler saw the issue differently yesterday. "I still believe the customer has a right to know what the broker has received from the fund or fund family in exchange for recommending that transaction," he said.

Sun reporters June Arney and Bill Atkinson also contributed to this article, as well as Chicago Tribune reporter Andrew Countryman.

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