Accused

A small-town, Midwestern Edward Jones rep is sitting at his desk on a brisk Friday morning in January, checking his messages, returning some emails, preparing for the day's meetings. His assistant comes through on the speakerphone. One of his clients, who happens to be his 13-year-old son's schoolteacher, wants to speak with him, and it sounds urgent. The assistant puts the client through.

The client is furious. She has just picked up that morning's Wall Street Journal, to find a story, on the front page, carrying the inflammatory headline, “Why a Brokerage Giant Pushes Some Mediocre Mutual Funds.” The story maintains that Edward Jones brokers steer clients into seven fund families' offerings because Jones receives payment from those “preferred” funds without disclosing it to their clients. Further, The Journal story asserts — as do a number of class-action lawsuits against Edward Jones filed after the story ran — that brokers are discouraged from meeting rival fund family representatives and are given bonuses based, in part, on selling the preferred fund families' offerings. (The firm denies the charges.)

The woman is screaming, accusing the rep of “ripping her off” and “trying to pull some Martha Stewart bullsh-t.” The rep, who runs a conservative, buy-and-hold practice in a sleepy Bible Belt village of less than 15,000 people — from a storefront office next to the DMV — was shocked. He had a positive relationship with the client for years.

“It was something weird, that's for sure,” the broker says. “She's acting like I'm Michael Milken and living in some mansion off her retirement money. I certainly never had anything like that happen before.”

Not that every Jones rep received such flak from clients. In fact, Managing Partner Doug Hill, who took over the top spot at Jones just days before the Journal story hit, says the story's effect on the firm's clients was minimal. “In a lot of the communities where we have offices, it had no major effect,” he says. “The majority of our customers simply aren't the type of people who read The Wall Street Journal.”

And that's just the point: Given Jones' middle-class clientele, what kind of impact will the revenue-sharing controversy have on Jones' reputation? Or worse, what impact could the mutual fund reforms have on the firm's core business, the selling of mutual funds? The SEC is in the midst of a complete examination of how mutual funds are sold and how firms and their brokers are compensated. To a firm like Edward Jones, which derives 43 percent of its revenue from mutual fund sales, widespread changes could cause some serious problems. “Mutual funds are their top earners,” says Andre Cappon, president of CBM Group, a New York-based industry consultant. “They can't mess around with them too much, or they could find some trouble.”

For years, Jones, one of the last partnerships among major brokerages, has feasted on its folksy, conservative image. Jones has built a network of some 9,000 offices, usually staffed by a single advisor, who cater to retirees, small-business owners and other individual investors located in suburban and rural towns. Such a focus is in direct contrast to the high-net-worth model currently in vogue on Wall Street. Its advisors usually are trained by the firm and must hew to the company's conservative investing philosophy of tried-and-true mutual funds, blue-chip stocks and highly rated fixed-income investments. Some even sell insurance. Jones reps are notoriously loyal to their firm. After the first year of employment, the firm has a 90 percent broker retention rate. The firm also has ranked first in Registered Rep.'s yearly Broker Report Card survey — where reps rank their own firms — for 15 consecutive years.

Known as the Wal-Mart of Wall Street, the strategy has proved to be successful, with the firm recording consistently strong profits over the years, say analysts who follow the industry. (In 2003, for example, revenue increased 12 percent in 2003, up to $2.5 billion.)

During the other scandals of recent years, Edward Jones, which also has a tiny investment banking unit, escaped unscathed. Indeed, mostly located far from the big cities, much less Wall Street, Jones has been able to paint itself as the outsider, an outsider with only the clients' best interest in mind. Consider: Jones' clients' average holding period of a mutual fund is around 10 years. In the late 1990s, during the technology bubble, management discouraged its brokers from putting clients in tech funds.

But suddenly, the firm has some explaining to do: The SEC may fine the firm for failing to disclose some $90 million in fees it collected from some mutual fund companies in revenue-sharing arrangements last year. It's important to understand that revenue-sharing deals (in which mutual fund companies pay brokerages for selling their funds) are not illegal. In some ways, such arrangements make sense, since networks of distribution, especially one the size of Jones, are scarce compared to the commoditylike nature of asset managers (there are more mutual funds than there are stocks traded on the NYSE, for example). Further, Jones can be proud that it was never implicated in any market-timing or late-trading scandals, though the firm did pay out a small amount ($18,000) in restitution for failing to give clients breakpoint discounts on some mutual fund trades.

Revenue sharing, despite the intense scrutiny it's under these days, is hardly a new concept and hardly one limited to Edward Jones (Morgan Stanley settled its own revenue-sharing issues with regulators in November for $50 million). Jones, while fully cooperating with regulators, is still confused over the matter. “It's our belief that our sales practices regarding mutual funds, and specifically revenue-sharing arrangements, were in conformance with historic pronouncements on the subject issued by the SEC, the NASD and other regulators,” says Larry Sobel, general counsel at Jones.

Whither the Future?

Yet, the NASD, NYSE, SEC and the U.S. Attorney General's office are “seriously considering” regulatory action against the firm for the revenue-sharing allegations, Jones stated in its 10-K. The 10-K also revealed nine different class-action suits against the firm. Many feel that the smudge on Edward Jones' reputation is negligible, and that the lawsuits won't further drag the firm's name in the mud, since some informed observers suspect the firm will settle rather than go to court.

Sobel says the firm intends to “fully comply with any resultant changes in rules and statutes.” For a firm so heavily weighted in the mutual fund area, even the slightest changes in regulatory policy could have negative consequences on its business, because so much revenue comes from mutual fund sales.

The SEC's most recent proposed rule does not call for the banning of revenue-sharing arrangements altogether, instead insisting on further disclosure, including notices to customers on arrangements both “at the point of sale and in transaction confirmations.” But an SEC spokesperson says there could be more regulation to come, depending on further research and inquiries.

Either way, almost everything is on the table. The SEC has proposed banning directed brokerage, the practice of directing trades to broker/dealers' trading desks to reward them for selling an asset manager's mutual funds. (The mutual fund industry's lobbyist, the ICI, supports this ban.) The SEC may also recommend that 12b-1 fees be eliminated, arguing the rule helps funds hide distribution costs from retail investors. (The mutual fund lobby argued against this proposal.) In a bluntly worded statement earlier this year, SEC Chairman Bill Donaldson wrote, “Rule 12b-1 fees and directed brokerage quietly generate a lot of money for people in the fund and broker/dealer industries, and unlike some of our other proposals, this one is going to hit them where it hurts.” Interestingly, when he read the statement at the SEC's Feb. 11 meeting, Donaldson softened his language to say the proposals “will have a major financial impact on people in these industries.”

Being so heavily dependent upon mutual funds, Edward Jones could suffer disproportionately compared to other firms. While Jones doesn't break out its 12b-1 fee gross, firms typically gross up to 100 basis points a year on assets invested, but, on average firmwide, substantially less. An SEC official says 12b-1 fees generated $13 billion last year for the brokerage industry. Revenue sharing, like 12b-1 fees, is important, too. Jones says in its 10-K that it received $90 million through revenue-sharing arrangements in 2003. Typically, such revenue-sharing arrangements are disclosed in fund prospectuses, often under the statement of additional information section.

Such deals are not often mentioned by brokers to their clients, however. Imagine having that conversation? Sources at Edward Jones say they haven't changed any of their disclosure policies in the wake of the investigations; they've always been, according to insiders, plainly listed as “preferred funds” on the firm's Web site. (Details in the prospectus are typically handled by individual mutual funds; reps aren't required to talk about fees, but are required to hand over a prospectus to clients before investing.)

While Congress and regulators troll for comment about the proposals, no one knows how this will pan out. “No one knows how they're going to come down,” Jones' Hill says. “We'll just go about our business and abide by whatever they tell us.”

Insiders at Jones argue that Jones' revenue-sharing arrangements are not only within the rules, but have been disclosed to clients for years. (They have also denied allegations that reps have been incentivized, through bonuses or trips, to sell certain funds.) Management also says Jones has used several of the fund families — including the popular American Funds — long before revenue sharing became a practice. What's important, Hill says, is for funds to “share our values.”

The other funds that Jones has a “preferred” relationship with are, according to the 10-K, Lord Abbett, American Funds, Federated Funds, Goldman Sachs Funds, Hartford Mutual Funds, Putnam Funds and Van Kampen Funds. Many of these fund families have had a relationship with Jones for decades. Says an executive of one of these preferred funds, “One of the cleanest and best-run systems is Jones. The brokers know the funds, and they are allowed to use others [nonpreferred funds].”

He adds, “They don't buy loosey-goosey funds, and they don't chase the hot dots. They stick with you [during down markets], which is what you are supposed to do.” He also points out that Jones' due diligence team follows the preferred funds and other companies on an “ongoing” basis and does not recommend all the funds of a preferred fund family — they may be too aggressive or don't have a long-enough track record. “They've done a good job for the masses. Of all the things in this industry that need to be cleaned up, I'm not sure that's [revenue sharing] at the top of the list,” the fund executive says.

Cappon concurs. “They have the most original business model of any major firm,” he says. “They combine the better features of a wirehouse and the better features of an independent. I think the scandal is a temporary hiccup.”

A hiccup in the firm's reputation? Probably. (Hill points out, “When you're in this business, these kind of situations come with the territory; it's not the first time I've seen ‘scandals.’”) Still, if major mutual fund reforms do ultimately come into effect, the Edward Jones of the future could be a far different animal.

“Listen, it's just logic, says one Jones rep. “Most of what I — and we — do is in mutual funds. If they radically change the way that works, it's gonna be a whole other planet out there. For all of us.”

At a Glance: Edward Jones