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Ongoing Enforcement Raises Eyebrows: Industry Watchers Mixed Over Weight of Penalties


Although the fund industry continues to reel from 19 months of Fundgate, a few industry executives believe that neither the SEC's $20 million settlement with Citigroup nor the $6.25 million fine NASD imposed on the company over improper sales disclosure went far enough.

NASD's fine against Citigroup Global Markets is part of a larger, $21 million action that also levies $13 million against American Express Financial Advisors and $2 million against Chase Investment Services for similar disclosure failures. The SEC and NASD carried out the investigation jointly.

Also on March 24, Putnam Investments was hit with yet another enforcement action from the NASD and SEC, this time a $40 million settlement over directed brokerage.

NASD enforcement chief Barry Goldsmith called the fines against Citigroup, Amex and Chase the largest Class B suit the brokerage industry regulator has ever brought.

Not everyone marked the occasion with such plaudits.

"The deals being cut are grossly unfair to consumers and small employers," said Greg Carpenter, president and CEO of 401(k) provider Employee Fiduciary, Mobile, Ala.

"Revenue sharing, shelf-space deals and pay-to-play arrangements in the 401(k) industry are an all too common and accepted practice. Unfortunately, the practices are so widespread that the market is fundamentally distorted and investors are unable to make informed decisions, thus perpetuating the abuse," he said.

Mutual fund and brokerage firm executives, however, could argue that the penalties are unfair because revenue sharing is considered a standard business practice industrywide. As far as directed brokerage is concerned, they might argue, the NASD, working in conjunction with the SEC, is pressing charges against sales practices dating back to 2002, even though the SEC put a rule prohibiting the practice on its books only last year. The NASD's position is that it has had an anti-reciprocal rule since the early 1970s, an argument American Funds, which has also been hit with directed-brokerage charges, takes issue with.

Christine Benz, an analyst at Morningstar and editor of the Chicago fund tracker's new Fearless Investing series of mutual fund workbooks, agrees with the regulators that revenue-sharing and directed-brokerage disclosures throughout the investment management industry have been clouded.

"Even though these sales practices may have been legal, many of the parties involved, both fund shops and brokerage firms, were clearly not doing their fair share to ensure that investors received adequate disclosure," said Benz, whose firm has been a vocal critic of certain fund industry practices since the scandal broke.

"Although the fund scandal initially erupted over trading abuses at certain firms, the whole gamut of fund sales practices, from directed-brokerage arrangements to revenue sharing, ultimately has a far bigger impact on the typical investor's bottom line than does improper trading," she said, noting that the SEC's pledge to beef up point-of-sale disclosures comes as gratifying news.

Regulators would not disclose how they discovered the wrongdoing at Citigroup, Chase and Amex, although Elaine Greenberg, assistant district administrator at the SEC's Philadelphia office, said this is an area the regulator "has been taking a hard look at."

Taken together, the various disclosure failures impacted 275,000 transactions and more than 50,000 households. The firms will make restitution to investors who were impacted.

The SEC's share of the investigation involves two distinct disclosure failures at the Citigroup unit, which offered retail brokerage services under the Smith Barney trade name.

For starters, according to the SEC, the Citigroup unit failed to disclose its revenue-sharing procedures to customers, known as the Tier program, whereby 75 mutual fund complexes made payments in return for preferred shelf space. CitiGroup, SEC officials noted, sold only those funds of mutual fund complexes that participated in the program. Benefits included increased access to branch offices, greater agenda space at sales meetings and visibility in the broker's in-house publications and broadcasts.

The second disclosure failure relates to Citigroup's sales of Class B shares of mutual funds in amounts of $50,000 or more. SEC officials said that the broker recommended and sold the shares to certain customers who, depending on the investment and the holding period, could have obtained a better rate of return if they had purchased Class A shares instead. The customers would have qualified for breakpoints beginning at the $50,000 level. As a result of the Class B purchases, Citigroup also received greater commissions than it would have earned on Class A shares of the same funds.

In short, financial consultants at the firm failed to inform customers that their returns could be negatively impacted by the 12b-1 fees inherent in the purchase of Class B shares, as well as the fact that breakpoints were available at the $50,000 mark.