SEC proposes rules for funds

A day after regulators slammed the mutual fund industry with fresh allegations of investor abuse, the Securities and Exchange Commission proposed new rules yesterday that would require brokers to tell their clients whether mutual fund companies have paid them to recommend certain funds.

The agency also proposed rules that would make fund boards more independent of company management and require investment advisers to adopt strict codes of ethics to govern their dealings with investors as part of a sweeping regulatory overhaul.


The regulations are the latest in a flurry of proposals the agency has made since September, when a probe of the industry revealed widespread unethical practices that have cost investors hundreds of millions of dollars and tarnished the reputations of some of the most prominent names in the industry.

"It's extremely troubling that so many of the recent scandals in the mutual fund industry have involved a breach of the fiduciary relationship between investment advisers and the advised funds," said William H. Donaldson, the SEC's chairman, in an opening statement before yesterday's meeting.


In the latest revelations, SEC officials said Tuesday that numerous brokerage firms have routinely failed to tell clients that they received payments from mutual fund companies in exchange for recommending their funds. An investigation found that 13 of 15 firms studied admitted to taking such payments, but only half said they told clients about the deals.

Industry analysts say the practice has been widespread for years. Some say such abuses have grown in proportion to the money flowing into mutual funds, now more than $7.2 trillion.

"We have created a culture [in the industry] where you maximize your profits and the investor should fend for themselves," said Tamar Frankel, a law professor at Boston University and an authority on mutual fund regulation. "That doesn't work, and the danger is that the investor is at the end going to look for the door."

SEC officials said Tuesday that they are investigating eight brokerage companies and a dozen mutual fund firms in connection with the undisclosed payments. Officials also are looking at whether fund boards knew about the arrangements. Such payments come out of investors' pockets, often without their knowledge.

At its meeting yesterday, SEC commissioners voted 5-0 to require brokers to tell customers about the so-called "revenue sharing" payments at the time of sale. In addition, investors would receive a detailed breakdown of the fees they paid in their statements.

The statements would have to disclose in dollar terms how much the customer paid in sales commissions and so-called 12b-1 fees, which are meant to allow fund companies to recover marketing costs. In addition, investors must be given information that will allow them to compare those fees to the industry average.

A separate proposal calls for fund managers to report their own trading in the funds in an effort to ensure that managers are not using inside information for their own gain.

"Mutual fund investors deserve full, clear and timely disclosure of all fees that come out of their pockets," said Cynthia Glassman, a Republican commissioner who voted for the measure.


The Investment Company Institute, which represents the mutual fund industry, backed the SEC proposal on disclosure, saying it has been calling for the change since the mid-1990s.

"The SEC's proposals are bold and far-reaching," said Matthew P. Fink, president of the trade group. "... When we review today's proposals in more detail, we may not agree that every change will achieve the benefits that are hoped for. Nevertheless, the mutual fund industry is confident that the reforms the SEC ultimately enacts will greatly strengthen mutual funds and make them better guardians of middle America's long-term investments."

Arthur Levitt, a former SEC chairman who has spoken in favor of more disclosure, said the regulatory measures will help restore investor confidence.

"I think the biggest problem that investors have had with mutual funds is the lack of transparency, and these recommendations go to the issue of transparency," he said.

Analysts said the disclosures may put pressure on mutual fund companies and brokers to lower their fees, which critics say have soared along with the popularity of mutual funds among everyday investors.

"It is definitely going to change the way people shop for investments," said Mercer Bullard, a former SEC attorney and founder of Fund Democracy, a shareholder advocacy group in Oxford, Miss.


The SEC commissioners also voted unanimously yesterday to require that mutual fund chairmen and 75 percent of mutual fund directors be independent of the companies that manage the funds. The rule is aimed at making the boards tougher watchdogs of the funds they oversee. Directors would be given authority to hire their own staff to research management fees and provide other advice.

In addition, boards would have to retain certain documents, including those used to help determine fund management fees.

If enacted, the proposal would force many of the nation's largest fund companies, including Fidelity and Vanguard, to oust the leaders of the boards of their funds. The Investment Company Institute has opposed the measure requiring chairmen to be independent.

Baltimore-based T. Rowe Price said meeting the 75 percent requirement would not be a problem, because two-thirds of its directors are independent and another is being named. But the company would have to replace its fund chairman with one who is independent.

"Our feeling ... is that you should not hamstring the directors," said Henry Hopkins, Price's chief legal counsel. "You should let them elect who they think is the best and most appropriate, and who would be the most effective chairman."

That sentiment was shared by Glassman and Republican commissioner Paul Atkins, both of whom questioned the need for independent chairmen and more directors who are independent.


Glassman noted that Boston-based Putnam Investments and some of the other fund companies rocked by scandal in recent months had independent chairmen in place before the allegations of improper trading. She said the requirement may serve to increase costs to investors without providing any benefit.

"It may put form over substance," she said.

But industry critics have long complained that mutual fund boards are too passive, serving as little more than a rubber stamp for the management companies. In most cases, boards are led by a chairman who works for the company that manages the fund.

"The boards really do have to act independently to serve fund investors well," said Russ Kinnel, director of funds research at Morningstar Inc., an independent fund research and analysis company in Chicago.

The SEC will gather public comments on the proposals before taking a final vote.

Proposed SEC rules


Independent fund chairman

At least 75 percent independent directors

Disclosure of any fees brokerage receives from fund company at the time of sale

Fees itemized on transaction statement

Fund managers must disclose their personal trades in the fund

Strict code of ethics