Suspect Favored Fund Company Treatment

Physician's Money Digest, May 31 2004, Volume 11, Issue 10

Wall Street Journal

The issue:

According to a report, the SEC has begun probing the sales practices of brokerage firms that get paid to push certain funds over others. The payments fund companies make to brokerage firms in exchange for placement on the firm's preferred lists. According to the article, the SEC recently examined 15 broker-dealers and found that 14 of them received cash payments from certain fund groups.

If that's going to occur, says Stephen Cutler, director of the SEC's enforcement division, then customers have a right to know what the incentives are for the selling broker when a particular fund family is recommended. And while brokers are required to disclose information about any revenue sharing arrangements, they have been able to meet this requirement by providing investors with a fund prospectus that indicates the amount of money being paid to the broker for the sale of mutual fund shares.

Preferential Problems

The problem with these special arrangements, notes the article, came to light last November. The SEC and the National Association of Securities Dealers charged Morgan Stanley with failing to inform clients that certain mutual fund companies received preferential treatment in exchange for millions of dollars in brokerage commissions and cash payments. The case was settled without Morgan Stanley admitting or denying guilt.

When it comes to revenue sharing practices, fund companies argue that having a spot on a broker's preferred list is no guarantee of future sales. But according to the article, it does result in greater visibility, thereby increasing the chance that the broker will recommend that company's funds. In addition, brokerage firms frequently invite fund companies on their preferred lists to speak with top producers or help train rookie brokers.

Consumer Investors

The manner in which these special arrangements are structured varies. But it's hard to dispute the impact these arrangements have. For example, according to the article, seven mutual funds on the preferred list at Edward Jones & Company accounted for 90% to 95% of the $26 billion in fund sales for the firm last year. Smith Barney divides mutual fund groups into three tiers. Fund groups in the first tier receive the most preferential treatment.

The SEC is now investigating eight brokerage firms and 12 mutual fund companies. They're also examining dozens of broker-sold mutual funds. And while physician-investors don't often think about the relationship between their broker and their mutual fund company, they should.