Federal securities regulators churned out two more mutual fund reforms last week as directed-brokerage practices were officially junked and portfolio managers met with new standards for disclosure.

In an open meeting Wednesday, the Securities and Exchange Commission continued its efforts to clean up the fund industry by amending rule 12b-1 under the Investment Act of 1940 to prohibit the use of brokerage commissions to finance distribution. A panel of five commissioners voted unanimously to approve the new rule, one aimed at eliminating a serious conflict of interest between funds and their advisors.

"Directing brokerage is not a particularly attractive use of fund assets," said Gary Gensler, former undersecretary of the Treasury and author of "The Great Mutual Fund Trap," about the practice of channeling of brokerage commissions to Wall Street firms in return for shelf space.

The distribution channels for mutual funds have become much more limited in recent years, as assets have swelled and more players have taken the field. As a result, funds are facing greater pressure to obtain better shelf space in an increasingly crowded marketplace.

Given the lack of elbowroom, many fund companies have been doling out financial incentives to brokers who pitch their funds under the guise of rule 12b-1. These informal arrangements have since spurred a conflict of interest that regulators believe has caused investors to pay excessive fees and compromised the best execution of fund trades.

"The division is concerned that these arrangements are far from the benign arrangements originally approved under rule 12b-1," said Penelope Saltzman branch chief of the office of regulatory policy in the SEC's division of investment management. "They involve substantial conflicts of interest that can harm funds and their shareholders." She added that directed-brokerage practices, "corrupt the relationship between brokers and customers and compromise best execution."

Under the new rule, mutual fund complexes will still retain the right to pay for shelf space, but can no longer steer fund transactions to brokers as a reward for selling their proprietary funds. However, funds will be prohibited from using so-called "step-out" arrangements designed to compensate selling brokers by directing to them commissions from portfolio securities transactions executed by other broker/dealers.

Realizing that funds would need to use a selling broker to put through trades in order to achieve best execution, the rule would allow a fund to use its selling broker to execute transactions only if it has the proper procedures and policies in place to prevent those tasked with selecting the brokers from taking into account brokers' distribution efforts.

Paul Schott Stevens, president of the Investment Company Institute, called the move a "milestone that will benefit fund investors and strengthen the operating integrity of mutual funds."

When questioned by the commissioners about what his staff plans to look for in its examinations, Robert Plaze, associate director of the SEC's division of investment management, said a fund complex's chief compliance officer must meet with the selling broker to make sure it understands fund policies. The CCO will be expected to determine whether or not there are any informal arrangements in place, he said.

Ongoing Conflicts

While perceived to be a step in the right direction, some industry observers believe there is more work to be done. "There are still inherent conflicts of interest when a broker is selling you mutual funds," Gensler said. "Brokers still have a tremendous personal challenge when they have two funds and one of them is paying him to bring it to your attention and the other one is not. Banning directed brokerage is a good incremental step but there are still many revenue-sharing arrangements."

Gensler favors abolishing rule 12b-1 altogether, an idea that has been floated in several mutual fund reform bills proposed in Congress. The SEC said it will continue to examine the 12b-1 issue to determine what more can be done to promote transparency in mutual funds.

"They're addressing one clear conflict of interest that needed to be done away with, so it's an important step," said Russ Kinnel, director of mutual fund research at Chicago-based fund tracker Morningstar, of the latest move. "[However], there is the larger issue of revenue sharing that still needs to be addressed," he added.

The Commission is currently probing more than a dozen of the largest mutual fund shops for improper revenue-sharing arrangements. In March, MFS Investments was forced to pay a $50 million fine for failing to disclose its arrangements with broker/dealers to board members and shareholders.

Meanwhile, the SEC also approved a series of rules designed to enhance disclosure regarding portfolio managers, including their compensation structure, ownership of fund shares and the identification of other portfolio management team members. The amendments would require a fund to spell out in its statement of additional information the pay structure of its portfolio management team and what metrics are used to determine it. For example, a fund would have to tell its shareholders whether its portfolio managers' salaries and bonuses were based on short-term or long-term performance relative to a particular benchmark.

Another key provision handed down is that portfolio managers have to disclose their stake in the funds they manage or what has been commonly referred to as "eating your own cooking." The idea there is to better align the interests of portfolio managers with those of investors. In other words, you are more likely to place a bet through someone if you know he or she has their own money on the line. Additionally, if a portfolio manager oversees other accounts, the fund must disclose the details of those accounts and any material conflicts of interest that may arise in connection with those accounts.

The amendments also require funds to disclose more information about those tasked with running their funds, particularly when a management team oversees a fund. That information would include their names, titles, experience and role on the management team. While the commissioners didn't entirely agree on the language of the rule, they agreed that this additional information would "remove the curtain" and "encourage fair play."

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