Goodbye Wall Street research scandals. Hello mutual fund marketing reform. In June, the SEC and Congress turned the regulatory spotlight on mutual funds. On June 11, Richard Baker (R-La.) introduced the Mutual Fund Integrity and Fee Transparency Act — a measure that would not only affect the way mutual fund companies market their wares, but could have a far-reaching impact on the way firms and their reps do business.

While the general thrust of the reform seems harmless — to show clients what funds actually cost and the arrangements firms have with fund manufacturers — the measure would, according to industry executives, fall heavily on brokers. There, at the point of sale, reps could wind up spelling out all costs and fees as well as any deals that he and his company have with the fund manufacturer.

Not only would this make selling funds more time consuming, it could scare off clients and provide the grounds for legal action if the fund does not perform well. One mutual fund executive thinks that the information is going to be used the wrong way. “All this is going to do is open the commode, so to speak,” he says. “Tort lawyers will be all over the place in bear markets, saying, ‘You should have gotten the lowest priced fund.’ It's going to get ugly.”

To be sure, there's room for improvement in fund selling. “The process is pretty poor,” concedes another mutual fund executive. Even though 95 million Americans own fund shares, they remain frightfully ignorant of what they pay for. In its critique of fund marketing, issued on June 9, the SEC cited a Vanguard/Money Investor “literacy test” in which 62 percent of investors didn't understand that fees reduce returns.

The problem for reps is that they sell 80 percent of all mutual funds. So that's where the burden of carrying out the new law — if it passes — would likely fall. “The SEC can talk about disclosure all they want, but at the end of the day it's the broker who still has that one-on-one relationship with the client,” says the fund executive.

In particular, reps may find it uncomfortable to justify the marketing arrangements with funds that boost their compensation. “When a broker sits there and says, ‘I'll recommend five mutual funds’ and doesn't tell you that XYZ funds are paying him and his brokerage firm, and he's not telling you how expensive they are relative to the Vanguard fund fees, that's where the greater burden of disclosure comes in,” says Larry M. Elkin, owner of Palisades Hudson Financial Group in Scarsdale, N.Y. The upshot could be that brokers voluntarily sell the cheapest funds — and settle for smaller fees.

Baker's bill calls on mutual funds to not only disclose more to consumers, but to hire more independent directors and to disclose how fund managers are compensated (information institutional investors already demand and get).

And it requires fund companies to disclose arrangements with distributors, including soft-dollar payments for research, directed trading and revenue sharing — the so-called “shelf space” issues. All these methods are used by fund marketers to get onto distribution platforms. But describing them, in addition to disclosing sales loads and 12b-1 fees, could make for some awkward client meetings.

Many of the recommendations that are embodied in the proposed bill were given to Baker by the SEC in its June 9 report. Written by Paul Roye, director of the SEC's investment management division, it concludes that competition is so fierce among fund manufacturers to get on B/D platforms that firms “appear to have a significant amount of leverage in dictating compensation levels.” And, fund companies and B/Ds together set “sales loads and rule 12b-1 fees at levels that they believe will provide sufficient incentives to broker-dealers to sell their fund shares.”

In May Roye told reporters that brokers might be the ones who will be responsible for telling investors about revenue sharing, according to a Dow Jones News Service report. While the proposed bill does not carry specific language requiring brokers to communicate all the gory details, reps are clearly in the sights of the SEC. “It's the broker that knows the specific arrangement,” Roye told Dow Jones. “Maybe there's a case for the broker to make the disclosure at the point of sale.”

That is certainly not the way it works now. While there is already significant disclosure of fees and expenses (funds must disclose management fees, 12b-1 fees and “other expenses”) registered reps do not have to describe the sales charge, fees or revenue sharing, according to the NASD. They merely have to fork over a prospectus. In practice, brokers sell funds based on their performance and applicability to the client, who may not see a prospectus until after the sale.

Of course, the disclosures do have a sobering effect upon the clients — if they take the trouble to read them. James Bashaw, an investment advisor in Houston affiliated with LPL, likes to tell the story of his first mutual fund sale — to his mother. “When she finally got around to reading the prospectus she said, ‘I don't know if I ever would have bought it if I'd have read that first.’”

10 Years Ago in Registered Rep

“Over the next five years, we'll start seeing a lot of brokers producing $8 million to $9 million.”
— Linda Marcelli, then-head of Merrill Lynch's flagship New York branch, May 1993