Broker compensation deals among mutual funds are attracting more intense regulatory scrutiny for possible conflicts of interest as the $7 trillion mutual fund industry remains on the defensive.

Steering brokerage commissions to securities firms that sell a fund company's proprietary funds or that bring in new clients has been a longstanding practice at many fund shops. However, firms whose funds are sold through brokers and financial planners may find themselves in regulators' crosshairs for soft-dollar arrangements and other such questionable pay deals. One company, mutual fund giant MFS Investments of Boston, has temporarily suspended these so-called "quid pro quo" arrangements, according to a New York Times report last week.

A securities firm executive who has accepted directed commissions from MFS in the past told the newspaper that the company has imposed a 90-day suspension on the practice in order to evaluate what regulators might be looking for in their ongoing investigation of mutual fund business operations. A spokesman for MFS declined to comment on the nature of the firm's directed-brokerage practices.

The move came just days before Morgan Stanley reached a settlement with the Securities and Exchange Commission and National Association of Securities Dealers, which brought charges against the New York-based brokerage for setting up preferential arrangements with 16 mutual fund companies. The complaint included allegations that its fund managers were forced to pay higher fees and commissions to Morgan Stanley in exchange for the firm's brokers selling those funds.

Sending a Message

"Investors expect and are entitled to informed, objective, and untainted recommendations from their brokers and their firms when it comes to which mutual funds to buy," said Mary Schapiro, NASD vice chairman and president of regulatory policy and oversight. "[These] enforcement actions send a clear message that those who choose to embrace commissions, higher payouts and extra bonuses over their duty to render conflict-free advice to their customers will be sanctioned in the strongest of terms."

Morgan Stanley neither confirmed nor denied any wrongdoing in the settlement but agreed to pay $50 million in fines and relinquish profits. The company issued a statement expressing "regret" that its sales practices were inadequate. The recovered funds will be distributed to Morgan Stanley customers, regulators said. As part of the settlement, the firm must adopt enhanced disclosures and distribute a mutual fund Bill of Rights that explains the nature of its fee system and other important facts needed to make fully informed investment decisions (see SEC's "Investor's Bill of Rights," p. 8).

Regulators mandated that the firm retain an independent consultant to review the adequacy of disclosures related to the distribution of funds. Another key provision of the deal was that it can no longer accept soft-dollar payments for retail distribution of mutual funds. The case marked the second settlement for Morgan Stanley in three months. In September, the company paid $2 million to settle charges that its brokers engaged in improper sales contests to promote its own funds.

The debate over directed brokerage arrangements is nothing new but what is most troubling is that these kickbacks are coming at the expense of fund shareholders. Paying for shelf space has become a valuable marketing tool for mutual fund companies as more than two-thirds of the fund industry sells their funds through brokers and financial planners, especially since funds can no longer push performance.

And competition for shelf space has intensified over the last few years due to the consolidation trend that has emerged in the industry. With thousands of funds competing for limited space on brokers' shelves, these kickbacks grease the industry's distribution machine. Critics of the industry argue that kickbacks have kept mutual fund costs high in that managers are less likely to urge securities firms to trade at lower commissions.


A source likened this practice to "extortion," an intimidation tactic typically reserved for more menacing mafia types. The questionable part of these practices is that they are not part of the firms' selling agreement and often take place under the table. In fact, brokerage firm executives avoid putting these types of agreements in writing, a testament to their impropriety. But these arrangements can often be explained away as part of soft-dollar agreements or 12b-1 fees. Essentially, the only way Eliot Spitzer finds out about this is if someone tells him directly.

"Funds' sales practices have been defanged, leaving them vulnerable to virtually every other financial service provider," said Max Rottersman, president of, a research firm that analyzes fund costs for institutional clients.

"They're sitting ducks now."

Historically, complexes have always had the ability to readily sell funds because they had so much cash on hand, seeing as how the mutual fund industry is such a fee-rich business. That afforded them the flexibility to make the necessary deals with brokerages to sell their products. But if that flexibility is suddenly limited or taken away completely, how can they compete?

"They now have to come up with a new idea that the public is going to buy," Rottersman said. "They can't sell performance because they haven't delivered and, they can't give brokers a ton of money because they're being watched."

The E-mail Police

Fund firms don't know how the current scandal is going to shake out, so they're trying to make everything squeaky clean and stop all arrangements they're unsure about, he said. He noted that many fund houses are ordering certain employees to take extended vacations while they go through their e-mail.

Vanguard Group, the second-largest fund complex, is well positioned during this period of turmoil because it sells directly to the end client and has no revenue sharing or pay-to-play arrangements. This enables it to offer one of the lowest expense ratios in the marketplace.

Jeff Keil, vice president of Global Fiduciary Review at New York-based research firm Lipper, suggested that phasing out some of these arrangements with brokers could deteriorate a fund company's brand. "They have to implement a broader strategy and certainly look at other channels to sell their funds rather than relying on the muscle of a few big players," he said.

Fatter commissions tempt brokers to make recommendations that may or may not be suitable. More compensation can certainly jade a broker's view on the process. There's a very distinct possibility that other firms will also suspend arrangements for a period of time to examine their policies and decide whether there is commensurate benefit for the shareholders, Keil said.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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