• Brokers switched clients from one fund to another similar product to generate new commissions for themselves. This has been a particularly large problem in the arena of variable annuities, which are life insurance products that include mutual fund investments.
• Firms were accepting side payments from particular fund companies but failed to tell clients. Last fall, Morgan Stanley paid $50 million to settle SEC and NASD allegations that it failed to tell customers it was getting extra money from 12 fund companies to promote their products. Some of the payments were in cash, while others were in the form of "directed brokerage," in which the fund companies sent Morgan Stanley their stock- and bond-buying business in exchange for favored treatment by the firm's retail brokers.
The Securities and Exchange Commission, chaired by William H. Donaldson, has moved toward fund accountability.
(Dennis Brack -- Bloomberg News)
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Some critics say the current setup is untenable and should be changed. "IBM doesn't pay brokers to push IBM stock, but the whole mutual fund industry is premised on the idea of paying brokers to push mutual funds. You need to divorce the product from the salesperson. There's too much abuse," said University of Mississippi law professor Mercer E. Bullard, who runs a shareholder advocacy group.
But the industry defends the commission-based system, saying that some investors need help choosing investments and that commissions are a fair way of compensating brokers for their time and effort.
"You're getting advice, and there is value to advice. But it has to be paid for," said James D. Spellman, spokesman for the Securities Industry Association.
But perhaps not if that advice isn't completely unbiased, consumer advocate Roper cautions: "Brokers aren't necessarily looking to recommend the best possible funds for you. They're looking for the ones that are appropriate for you among the group that pays them highly."
Regulators for their part are opting for smaller fixes, focused mostly on disclosure. Brokers now have to do a better job of telling customers they may be eligible for breakpoints and must keep better records to ensure that the discounts actually materialize.
The SEC has also proposed banning directed brokerage and requiring brokers to tell their customers -- at the point of sale -- exactly how much the brokers and their firm receive for selling the products they are recommending. The SIA is lobbying hard against the point-of-sale proposal, saying it would be prohibitively expensive to provide individualized statements to each investor.
But mutual fund trade group ICI has come out in favor of it. "Disclosure at the point of sale is a very powerful tool to bring to an investor's attention those relationships that could influence a broker's recommendations," said the group's president, Paul Schott Stevens.
The SEC and NASD continue to look for new abusive practices but, in the end, regulators and academics said, customers must still look out for themselves.
"Examiners are focusing on the sales of mutual funds to investors, given their popularity, and we're looking for sales that may be unsuitable or inappropriate for the investor," said Lori A. Richards, who heads the SEC's compliance and inspection division.
"But it's important that investors be educated about what they are buying."
