Directed brokerage is no more.
In a move that surprised few, the SEC voted 5-0 Wednesday to ban “directed brokerage,” in which mutual fund managers direct trades through brokerages’ trading desks as a reward for selling their funds to retail clients. Perhaps more worrisome was the SEC’s call for comment on overhauling or banning outright 12b-1 fees, which it described as disguised commissions.
“Prohibiting directed brokerage makes sense,” said SEC Commissioner Harvey Goldschmid. “Putting it behind us is just the right thing to do.” The practice posed a potential conflict, the SEC said, because the practice could put the interests of the mutual fund manager ahead of the fund’s shareholders. (Commissions for fund trading are paid by the fund’s assets.)
Directed brokerage had been withering on the vine for months, since the SEC had already passed a rule saying any directed-brokerage arrangements would have to be approved by a fund’s board of directors—which in this environment was never going to happen. The tipping point for directed brokerage’s downfall might have been last year, when MFS Investment Management, under new Chairman Robert Pozen, became the first major fund to proclaim it would no longer direct trades. Several large funds followed suit, and, eventually, defenders of the practice were nearly impossible to find. Even the Investment Company Institute lobbied to have the practice stopped.
Several firms have been fined by the SEC for failing to disclose to investors such arrangements, including MFS and Morgan Stanley (although neither firm had to admit to any wrongdoing). Others companies, such as Franklin Resources and regional brokerage Piper Jaffray, may face possible regulatory action.
Registered Rep. sought comment but firms’ spokesmen couldn’t be reached or had no comment. Others favored the ruling. “We don’t have an execution capability here, so it doesn’t affect us—it’s housed in another b/d affiliated with Wachovia,” said a Wachovia spokesperson. “That said, we’re fully supportive of the change.”
The amount of potential revenue loss to firms is substantial; Merrill Lynch estimates that in 2003 the practice generated $300 million to brokerages. But will the ban save fund families any money? One major fund family estimates it paid about $35 million for “strategic relationships” last year. But some say fund companies may simply have to pay hard dollars to brokerages instead. This doesn’t bother regulators since, under this arrangement, such payments would be paid by out of fund companies’ own coffers and not by shareholders, eliminating the conflict of interest.
How will it affect individual advisors? It stands to reason that if funds were no longer to pay for distribution, brokerages would have fewer resources to spend on their advisors. But, since there are so many mutual funds all vying for shelf space on retail brokerage platforms, it’s hard to imagine that this would have much impact at all. Most likely, fund families will have to pay for distribution via brokerages.
“Everybody knew this was gone, so this is hardly news to us,” says an A.G. Edwards broker. “I don’t think anyone could justify the practice with a straight face.”
Perhaps of greater danger to advisors were the ominous comments in the announcement concerning 12b-1 fees, which compensate advisors for distribution and marketing costs. In reality, though, 12b-1 fees are hidden commission paid to brokers for selling funds.
12b-1 fees weren’t banned in the announcement, but SEC investment management division Director Paul Roye said the commission is “still evaluating what to do about the fees, which many regulators find a conflict of interest.” Some have suggested having the fees paid by individual shareholders or even banning the practice all together, which could have catastrophic consequences; the SEC estimates that the industry generated $13 billion in 2003 from 12b-1 fees.
The SEC says it will finish its investigations and recommendations by the end of the year.
