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Adequacy of Cost Disclosures Is Weighed


Broker/dealers could face pressure to provide investors with an unprecedented amount of detail about the special sales payments they receive from mutual funds and mutual fund companies as the result of a class action lawsuit that is moving slowly through the federal courts.

Investors have accused some of the most recognized broker/dealers in the securities industry - including Bear Stearns & Co. of New York, Donaldson, Lufkin & Jenrette Securities Corp.'s Pershing Division of Jersey City, N.J. and Fidelity Investments of Boston's National Financial Services Corp. subsidiary - of violating federal securities laws by inadequately disclosing to investors the amount of rule 12b-1 fees those broker/dealers receive from money market funds.

The precise amount of money at stake in the case is not clear, but investors contend that tens of millions of dollars in fees paid from money market funds to broker/dealers since 1980 were not adequately disclosed. Currently, 480 money market funds carry 12b-1 fees and have assets under management of about $564 billion, according to Lipper of Summit, N.J., the fund consulting and tracking firm.

The implications of the case, however, potentially go beyond just money market funds and 12b-1 fees, according to mutual fund lawyers.

The investors' key argument - that a 23-year-old SEC rule requires broker/dealers to tell investors each month the amount of money the broker/dealers receive from funds and fund companies for selling funds - conceivably could apply to all mutual funds and mutual fund companies that make payments to broker/dealers for fund sales, some fund industry lawyers say.

On Wednesday, the SEC is expected to address the matter. The U.S. Court of Appeals in New York - the most influential court in the country on securities law matters - has ordered the SEC to file a friend-of-the-court brief explaining how the SEC's own regulations apply when broker/dealers receive payments for money market sales. The securities and fund industries are eager to hear what the SEC has to say.

"It has very broad significance, conceivably," said Jay Neuman, corporate counsel for Federated Investors of Pittsburgh, Pa. of the SEC's expected pronouncement.

The origin of the dispute lies in one of the securities industry's most prosaic services - sweep accounts. Broker/dealers routinely forge alliances with fund companies to use the fund companies' money market funds. As part of the arrangement, broker/dealers sweep their customer's uninvested cash into a designated money market fund, known as the investor's sweep account.

The money market funds then normally pay the broker/dealer for services the broker/dealers provide investors. The payments can come in the form of a rule 12b-1 fee or as part of a separate agreement by which fund advisers pay broker/dealers out of the advisers' pockets.

Funds disclose the fact that they pay 12b-1 and other fees to broker/dealers in their prospectuses, but the descriptions usually do not identify the broker/dealers by name and do not provide details about the amount of the payments. Broker/dealers, for their part, do not disclose details about 12b-1 and other payments on monthly statements.

In 1977, the SEC adopted Rule 10b-10 of the Securities Exchange Act, which requires that broker/dealers make monthly disclosure to investors about the expenses they incur for securities sales. The failure to make monthly disclosures about the 12b-1 fees and other charges associated with sweep accounts violates Rule 10b-10, according to the investors suing broker/dealers. Investors are entitled to know how much they are paying for the services they receive, according to the plaintiffs.

"It's just totally unknown even to sophisticated investors that this is going on," said one of the shareholders' lawyers, Stuart Wechsler of Wechsler Harwood Halebian & Feffer LLP of New York. "It's an outrage that [the charge] is not disclosed, even absent SEC rules. It's a kickback, a hidden charge."

A federal judge did not see it that way three years ago. U.S. District Court Judge Robert Patterson of New York dismissed the shareholders' case in a ruling on Aug. 8, 1997. The broker/dealers may have violated some of the technical requirements of Rule 10b-10, but they did not commit fraud, Patterson ruled.

Patterson reached his ruling by relying on a 1979 interpretive letter from the SEC. In the letter, the SEC said that broker/dealers did not need to disclose sales-related expenses under 10b-10 so long as investors received a prospectus.

In 1994, however, the SEC took a step toward reversing itself. The agency said in an interpretive letter that it would abandon its 1979 interpretation and require broker/dealers to make additional disclosures of expenses with respect to fund sales. The SEC, however, never issued a rule or additional pronouncement formally revoking the 1979 interpretation.

The investors appealed Patterson's decision. The Court of Appeals now wants to know the SEC's current interpretation of its own rules.

The SEC's five commissioners were scheduled to review the SEC staff's analysis at a closed meeting Feb. 9. An SEC spokesperson declined to comment on where the agency would land on interpreting 10b-10.

The SEC's review itself, however, has been exasperating to Wechsler. In preparing their interpretation in recent weeks, SEC lawyers talked to representatives of the Investment Company Institute and the Securities Industry Association. Those moves raise concerns that the agency is "too sensitive to the industries' self-serving views," Wechsler said. If the SEC decided to meet with industry representatives, it also should have discussed the matter with consumer advocacy groups, Wechsler said.

An SEC spokesperson declined to comment, as did a representative of the ICI. An SIA spokesperson with knowledge of the matter was not available for comment.