Directed Brokerage Goes Down for the Count

The first target has been hit: Directed brokerage is no more, and 12b-1 fees might be in more danger than had been thought. The SEC's recent ban on the practice of directed brokerage was expected. The same cannot be said for the ominous comments in the announcement concerning 12b-1 fees, which are supposed to compensate advisors for distribution and marketing costs related to funds sales but which,

The first target has been hit: Directed brokerage is no more, and 12b-1 fees might be in more danger than had been thought.

The SEC's recent ban on the practice of directed brokerage was expected. The same cannot be said for the ominous comments in the announcement concerning 12b-1 fees, which are supposed to compensate advisors for “distribution and marketing costs” related to funds sales but which, its critics say, is a reward for selling the funds. Reps say the fee should be viewed as a client servicing trail.

12b-1 fees weren't banned in the announcement, but SEC investment management division director Paul Roye said the commission is “still evaluating” what to do about the fees. Some say the fees should be paid by individual shareholders by a sale of fund shares, or be banned all together, which could have huge consequences. The SEC estimates that the brokerage industry generated $13 billion in 2003 from 12b-1 fees. For many reps, it is a big part of their compensation.

“Take those away, and everybody's hurting,” says one Morgan Stanley rep. “That's huge money gone, gone.”

Sen. Peter Fitzgerald (R, Ill.) — who is not running for re-election and will likely be suceeded by rising star Barack Obama — is attempting to push through legislation to ban 12b-1 fees before he leaves office. Few think he will succeed, but the fees still appear to be in more danger than some had initially anticipated. SEC Chairman William Donaldson had initially backed off strong negative statements about 12b-1 fees, but the fees were mentioned enough in the directed-brokerage announcement to make it clear the topic is still on the table — and this makes many reps nervous.

The amount of potential revenue loss to firms is substantial; Merrill Lynch estimates that in 2003 the directed trades generated $300 million to brokerages.

But will the ban save fund families any money? One major fund family estimates it paid about $35 million for “strategic relationships” last year. But some say fund companies may simply have to pay hard dollars to brokerages instead. This doesn't bother regulators since, under this arrangement, such payments would be paid out of fund companies' own coffers and not by shareholders, eliminating the conflict of interest.

Several firms have been fined by the SEC for failing to disclose to investors such directed-trading arrangements, including MFS and Morgan Stanley (although neither firm had to admit to any wrongdoing). Others, such as Franklin Resources and regional brokerage Piper Jaffray, may face possible regulatory action.

Registered Rep. sought comment, but firms' spokespeople couldn't be reached or had no comment. Others supported the ruling. “We don't have an execution capability here, so it doesn't affect us,” said a Wachovia spokesperson. “That said, we're fully supportive of the change.”

How will it affect individual advisors? It stands to reason that if funds were no longer to pay for distribution, brokerages would have fewer resources to spend on their advisors. But, since there are so many mutual funds all vying for shelf space on retail brokerage platforms, it's hard to imagine that this would have much impact at all. Most likely, fund families will have to pay for distribution via brokerages.

“Everybody knew this was gone, so this is hardly news to us,” says an A.G. Edwards broker. “I don't think anyone could justify the practice with a straight face.”

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