The Securities and Exchange Commission is expected to vote tomorrow to bar mutual fund companies from steering their stock and bond business to brokerage firms that promote the fund companies' products. The practice, known as directed brokerage, has come under fire as an area rife with potential conflicts of interest after scrutiny of the $7.6 trillion mutual fund industry intensified last year. Regulators have expressed concerns that such arrangements have led brokers to recommend products based on their own financial benefit, no matter whether the investments are appropriate for particular clients.
Regulators are probing alleged conflicts at more than a dozen firms. In March, Massachusetts Financial Services Co. paid a $50 million civil penalty for failing to disclose its arrangements with brokerage firms to trustees and shareholders. Separately, Morgan Stanley DW Inc. paid a $25 million penalty last year in part to settle similar charges. The firms did not admit or deny wrongdoing as part of the deals.
If the SEC approves the ban, "those who are willing to dance closer to the line are no longer able to do so," said University of Mississippi law professor Mercer E. Bullard.
The proposal has won support from key business groups, including the Investment Company Institute, a trade association for mutual funds.
"Prohibiting the allocation of brokerage based upon sales considerations is warranted because the practice of directed brokerage can give rise to the appearance of conflicts of interest," wrote ICI senior counsel Amy B.R. Lancellotta in a May letter to securities regulators.
Likewise, Securities Industry Association associate general counsel Michael D. Udoff said his group supports a ban against quid pro quo deals. But the SIA has asked regulators to clarify that the ban would not preclude mutual fund companies from paying brokerages for services that could help investors, such as faster execution of trades.
"There are going to be many situations where firms that distribute substantial numbers of shares also have the most deep trading desks," Udoff said in an interview.
Also tomorrow, the five-member SEC is expected to approve new disclosure requirements that would force fund portfolio managers to provide more information about their personal investments in the funds.
The votes are the latest in a wider platform of SEC initiatives designed to prevent trading abuses in the mutual fund industry. Already the agency has required funds to disclose more information about fees and to hire compliance officials to ensure that they are following the rules.
But consumer groups want the SEC to go even further in the fee arena. Several prominent investor advocates have proposed an outright ban on the use of trading commission dollars to pay brokers for stock research and related services. The Mutual Fund Directors Forum recently endorsed such a ban in a report to SEC leaders, drawing fire from industry groups and independent research firms that depend on the money.
The NASD has a task force examining so-called soft-dollar issues, but the SEC is not actively considering a broader ban, according to a source familiar with the deliberations who was not authorized to speak publicly.
"The real sleeper here is whether the SEC will tackle the bigger issue of [soft-dollar] fees," Bullard said.