The SEC may require mutual fund companies and broker/dealers to tell investors more about the special payments fund companies make to broker/dealers for selling funds.
The SEC will review revenue sharing practices in the mutual fund industry as the result of lawsuits that contend that such arrangements violate federal securities laws because they are not adequately disclosed, according to an agency lawyer. The review follows a decision by the SEC to consider adopting new requirements on revenue-sharing disclosure. The SEC revealed it was considering such a move in a court filing Feb. 11.
Revenue sharing is the common, legal practice in which fund advisers make special payments to broker/dealers for fund sales. The fund companies share the revenues they receive from managing funds with the broker/dealers who sell the funds.
A lawsuit before the U.S. Court of Appeals in New York prompted the SEC's moves. In the case, investors claim that broker/dealers violated federal securities laws because they allegedly inadequately disclosed their revenue-sharing practices.
The appeals court ordered the SEC to explain its rules on revenue-sharing disclosure to aid the court in reaching a decision. In a 30-page brief, the SEC said that disclosing revenue-sharing practices in a mutual fund prospectus satisfies technical requirements under current rules. But those rules, which date back to 1977, may need to be revised, the SEC said.
The SEC's five commissioners have asked agency lawyers to make recommendations to the commissioners on the issue, the SEC said in its court filing. There is no deadline by which SEC lawyers must make their recommendations, said Meyer Eisenberg, deputy general counsel for the SEC. The SEC ultimately could adopt new rules or provide guidance to the mutual fund and securities industries on how they must disclose revenue-sharing arrangements, Eisenberg said.
The review is expected to involve several groups within the SEC, including the division of investment management and the division of market regulation, Eisenberg said. He declined to comment on the scope of the review.
Broker/dealers use the money from revenue-sharing arrangements to pay fees and expenses associated with servicing mutual fund shareholders, according to fund and securities industry executives. Some payments, such as rule 12b-1 fees, are disclosed in detail in fund prospectuses. Other revenue sharing arrangements - such as payments that a fund adviser makes out of its own profits - usually are revealed only in broad terms, according to fund industry lawyers.
The plaintiffs in the pending litigation contend that undisclosed or inadequately disclosed revenue-sharing arrangements create a secret or opaque conflict of interest between a broker/dealer and its customers. The broker/dealer has a special incentive to sell one fund over another because of revenue-sharing payments, according to the plaintiffs. Federal securities laws require that such conflicts be disclosed unambiguously, the plaintiffs allege.
The SEC, in its court filing, acknowledged that there is no precise standard for how much disclosure is enough on revenue sharing.
Broker/dealers can satisfy the requirements of rule 10b-10 of the Securities Exchange Act - which requires at least monthly disclosure of sales charges - by providing investors with prospectuses that identify the existence of revenue-sharing arrangements, the SEC said. That disclosure, although it need not be detailed, should describe the extent of the revenue-sharing payments in general terms, the SEC said. For example, a prospectus that said revenue sharing payments were made in "significant amounts" met the requirements of rule 10b-10, the SEC said.
Nevertheless, broker/dealers still may violate anti-fraud laws even if they satisfy the 10b-10 requirements, the SEC said. In evaluating fraud claims, courts must decide if significant information was omitted from fund prospectuses or other documents and then decide whether those omissions were deliberate, the SEC said.
The SEC's filing provides support for the defendants in the pending litigation. The SEC said the broker/dealers - Quick & Reilly of New York, Bear Stearns & Co. of New York, the Pershing Division of Donaldson Lufkin Jenrette Securities of Jersey City, N.J. and Fidelity Investments of Boston's National Financial Services Corp. - did not violate rule 10b-10. The SEC refused to offer an opinion on allegations that the broker/dealers' conduct was fraudulent, a charge the firms have denied in court filings. A lower federal court had ruled in the defendants' favor in 1997.
A lawyer for the plaintiffs in the case, Stuart Wechsler of Wechsler Harwood Halebian & Feffer LLP of New York, said he would wait for a decision from the appeals court before deciding how to proceed. It is unclear when the court will rule on the case.
