NASD to Bring Broker Pay to Light
August 18, 2003
Courtside seats and free bottles of vino may be a thing of the past once regulators are through retooling broker compensation.
The National Association of Securities Dealers of Washington has proposed a rule that would require brokerages and their registered representatives to tell customers whether they receive higher commissions for selling certain mutual funds. Brokers would also have to publish, in rank order, a periodic list of mutual funds that pay them for shelf space.
Under existing regulations, brokers are required to disclose commission rates but are not obligated to tell customers how those incentives differ from other funds. In fact, fatter commissions, expensive gifts and revenue-sharing are pretty widespread practices among mutual funds similar to the way equity securities firms offer bigger payouts to certain brokers for recommending particular stocks.
The proposal would require firms to disclose the nature of their financial arrangements in writing when the customer signs up for an account or purchases shares. The information must be updated biannually and posted to the company's Web site as well. That also includes a fund's soft-dollar arrangements, which would be published in a fund prospectus's statement of additional information.
"When buying mutual funds, investors have the need and right to know about incentive compensation received by a member firm and its registered representatives, which often differs from fund to fund," said Robert Glauber, chairman and chief executive of NASD, in a prepared statement.
The move serves to alert investors to potential conflicts of interest that may exist behind the scenes and is part of a larger effort by regulators to review sales practices within the mutual fund industry.
State regulators, Congress and investor advocacy groups have had mutual funds in their crosshairs ever since a three-year bear market wiped out many investors' retirement savings. A major sticking point has been increased disclosure of the various fees and expenses funds charge for their services, which ultimately lower investors' returns. A government study released earlier this year revealed that expenses are trending higher as returns are getting lower.
To address this problem, the House passed the Mutual Fund Integrity and Fee Transparency Act. It calls for the periodic disclosure of the operating expenses that are borne by each shareholder of a fund, how the compensation for the portfolio managers are determined, what the transaction costs are, their commission policies and delivering on promises of breakpoint discounts.
In July, Massachusetts securities division launched an investigation into allegations that Morgan Stanley improperly pressured brokers and branch managers to sell proprietary mutual funds to investors, who were unaware that their brokers received additional compensation for pitching in-house funds. Citgroup is facing similar litigation for allegedly misleading investors by intentionally selling them B shares with the knowledge that they would pay higher sales charges and realize a smaller profit than if they had selected a different share class. Both New York-based brokerage giants are facing potential class action lawsuits.
With respect to the NASD proposal, it is essentially in step with what the Securities and Exchange Commission and Congress are doing from a regulatory standpoint, according to Michael Wolk, former VP and chief counsel of market regulation at NASD and a partner at the Washington law firm Foley & Lardner. "Generally, I don't think you're going to hear an argument from within the industry that it's a bad thing," Wolk said.
In terms of its impact on mutual fund companies, he believes there's a chance it could impact sales because investors may assume, correctly or incorrectly, that a broker wants them to buy a certain fund because they get paid more to sell it. Also, the practice of offering higher compensation for pitching in-house funds might vanish completely, Wolk said. "Firms may determine that it makes more sense to eradicate the practice rather than having to disclose it and try to justify it," he said.
The NASD will outline the details of its proposal in a notice to members and allow 30 to 45 days for comment. After the board considers these recommendations, they will send a final proposal to the SEC. Wolk said that the most important aspect of the proposal is that members take advantage of the comment period rather than waiting to see what is proposed to the SEC because it may not be something they like or the most efficient way of doing it.
The mutual fund industry supports the concept of disclosing compensation practices but as with most policy changes, the language of the document will be key. "We strongly support the idea of disclosing the incentives that are present at the point of sale," said John Collins, a spokesman for Investment Company Institute in Washington. "It is very good for mutual fund shareholders to know." ICI said it is looking forward to working with NASD on how to structure the new disclosure rule.
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