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Mutual Fund Enforcement Picks Up Steam

The recent flurry of mutual fund-related punishments from the SEC is likely just the beginning of a coming avalanche of similar regulatory actions, legal experts say.

The recent flurry of mutual fund-related punishments from the SEC is likely just the beginning of a coming avalanche of similar regulatory actions, legal experts say.

On March 23, the SEC and NASD handed out fines totaling more than $80 million to five firms, including Putnam, Citigroup, J.P. Morgan Chase and American Express Financial Advisors. The punishments were related to failures to disclose to clients revenue-sharing arrangements and the higher costs of mutual fund B shares.

Only a handful of companies have been charged since the SEC began its investigations into mutual fund sales practices in 2003. And though the actions taken by regulators so far might seem significant, legal experts say this is likely just the start. At last count, the SEC was investigating revenue sharing at the 15 largest broker/dealers, but it also has been conducting “revenue-sharing sweeps” at the independents, said Terry Lister, a longtime lawyer in the b/d industry and general counsel at the Financial Services Institute, an association that represents independent b/ds.

“I don't think they’re just trying to make an example out of one or two firms in the hopes that everyone gets the message,” said Lister. “What they typically do is they settle with one or two firms, and then they use that example as a template to obtain settlements from other firms. I do believe that there will be more of these cases involving revenue sharing. I think we've only seen the beginning.”

Proposed point-of-sale disclosure rules, which could require b/ds to provide additional details on B shares and revenue sharing, are expected to be finalized this year, and some b/ds have already started to provide additional disclosures on their Web sites.

The particulars of the most recent regulatory action are as follows:

The SEC levied fines of $40 million and $20 million on Putnam and Citigroup Global Markets, respectively, for failing to disclose the revenue-sharing payments used to promote certain mutual funds to clients. Citi also failed to disclose the higher fees associated with B shares, the SEC said. Capital Analysts, a small b/d based in Radnor, Pa., was fined a total of $450,000 for improper revenue-sharing arrangements with its mutual fund suppliers.

Meanwhile, the NASD meted out fines of its own—$13 million to American Express Financial Advisors, $6.25 million to Citigroup Global Markets and $2 million to Chase Investment Services—for steering investors to costlier funds.

Revenue-sharing deals, in which a mutual fund agrees to pay a b/d for “shelf space,” or access to the firm's rep force, are widespread in the securities industry, but the particulars of the agreements vary widely. B/ds may have anywhere between 10 and 50 funds on their preferred lists, and can accept payment through conference sponsorships, marketing and training support and/or hard cash. The SEC has already banned one form of revenue sharing called directed brokerage, where mutual funds would steer commissions to brokerages in exchange for shelf space. Regulators are mainly concerned that the deals be prominently disclosed to investors, so investors have a clear understanding of their advisory firms’ motivations.

B shares are under fire, meanwhile, because the NASD found in an investigation that brokers and advisors were recommending them to investors who would have been eligible for substantial discounts, called breakpoints, in A shares.

The short list of b/ds that have already been charged for failure to disclose their revenue-sharing deals includes Morgan Stanley, Edward Jones, and now Citigroup and Capital Analysts; fund companies include MFS Investment Management, Franklin Templeton and Putnam. The NASD has also charged American Funds, Quick & Reilly and Piper Jaffray for directed-brokerage agreements.

In its settlement, the SEC directed Citigroup to disclose certain details about its revenue-sharing deals on its Web site within 30 days, including the fund companies participating in its program and the maximum amount paid in basis points to participate. In addition, Citigroup has to hire an independent consultant, who is approved by the SEC, to review its revenue-sharing and B-share sales practices and disclosures and make recommendations.

Citigroup got a far sweeter deal than Edward Jones, who settled with regulators in December 2004. Edward Jones agreed to pay $75 million and make explicit disclosures about the actual amounts that it receives in revenue-sharing payments from each of the funds on its preferred list. That's partly because Citigroup began improving its revenue-sharing disclosures in July 2003, and created a system to block the sale of B shares where A shares would be more advantageous to an investor, says one securities lawyer.

Putnam was fined $40 million for failing to disclose the existence of revenue-sharing agreements with over 80 b/ds in its prospectus or statements of additional information. Twenty of these b/ds received cash payments, while the other 60-plus received directed-brokerage commissions from its funds.

In its settlement, Capital Analysts, a small b/d based in Radnor, Pa., agreed to pay a fine of $350,000, as well as a civil penalty of $100,000. The SEC found that even though the b/d had selling agreements with several hundred mutual funds complexes, only 11 to 15 fund companies participated in its revenue-sharing program each year. Participating funds paid an annual fee of $10,000 to $45,000 to participate in one of four tiers, with corresponding levels of benefits.

At least one lawyer said he didn't think the settlements would influence whether investors would do business with the affected firms. “These settlements generally have minimal impact on the public,” says Bill Singer, a New York-based attorney with Gusrae Kaplan & Bruno who represents small- and mid-sized b/ds and is a columnist for this magazine. “The public is once again learning there's corruption and fraud on Wall Street,” he says. “The public is sort of numb to this already.”

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